HARVARD

ISSN 1936-5349 (print)

ISSN 1936-5357 (online)

JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS

FELLOWS DISCUSSION PAPER SERIES

ON DERIVATIVES MARKETS
AND SOCIAL WELFARE:
A THEORY OF EMPTY VOTING
AND HIDDEN OWNERSHIP

Jordan M. Barry, John William Hatfield,

& Scott Duke Kominers

Discussion Paper No. 45

08/2012

Harvard Law School

Cambridge, MA 02138

Contributors to this series are John M. Olin Fellows or Terence M.

Considine Fellows in Law and Economics at Harvard University.
This paper can be downloaded without charge from:
The Harvard John M. Olin Fellows Discussion Paper Series:
http://www.law.harvard.edu/programs/olin_center/
This paper is also a discussion paper of the
John M. Olin Center's Program on Corporate Governance

ON DERIVATIVES MARKETS
AND SOCIAL WELFARE:
A THEORY OF EMPTY VOTING
AND HIDDEN OWNERSHIP
Jordan M. Barry,* John William Hatfield,**
& Scott Duke Kominers
Abstract
The prevailing view among many economists is that derivatives
markets simply enable financial markets to incorporate
information better and faster. Under this view, increasing the size
of derivatives markets only increases the efficiency of financial
markets.
We present formal economic analysis that contradicts this view.
Derivatives allow investors to hold economic interests in a
corporation without owning voting rights, or vice versa. This
*

Associate Professor, University of San Diego School of Law.

Assistant Professor, Stanford University Graduate School of Business.

Research Scholar, Becker Friedman Institute for Research in Economics,

University of Chicago. We thank Emily Keifer, Larry Alexander, Robert
Bartlett, Lucian Arye Bebchuk, Gary Becker, Abraham Bell, Tom Coleman,
Robert Daines, Lynne Dallas, Eddie Dekel, Dhammika Dharmapala, Donald A.
Dripps, Darrell Duffie, Steven Durlauf, Victor Fleischer, Ryan Ford, Jesse Fried,
Greg Ihrie, Louis Kaplow, Michael Kelly, Michael Klausner, Charles Korsmo,
Herbert I. Lazerow, Mark Lee, Katherine Litvak, Shaun Martin, Ian McKinley,
Casey Mulligan, Kevin Murphy, Roger Myerson, Derek Neal, Stirling
Newberry, Muriel Niederle, Frank Partnoy, Tom Phillipson, A. Mitchell
Polinsky, Elizabeth Pollman, Alvin E. Roth, Steven M. Shavell, Tom Smith,
Holger Spamann, James C. Spindler, Anthony Taranto, and E. Glen Weyl, as
well as attendees at the University of Chicago Workshop on Applications of
Economics, the National Business Law Scholars Conference, the Annual
Meeting of the American Law and Economics Association, the Annual Meeting
of the Econometric Society of North America, the Western Economics
Association International Conference, the Annual Meeting of the International
Society for the New Institutional Economics, and the University of San Diego
Law School Faculty Colloquium for their helpful thoughts and comments. All
errors are our own. This project was generously supported by a summer
research grant from the University of San Diego School of Law. Kominers
gratefully acknowledges the support of the National Science Foundation, a
Yahoo! Key Scientific Challenges Program Fellowship, a Terence M. Considine
Fellowship in Law and Economics funded by the John M. Olin Center at
Harvard Law School, the American Mathematical Society, and the Simons
Foundation.
**

leads to both empty votersinvestors whose voting rights in a

corporation exceed their economic interestsand hidden owners
investors whose economic interests exceed their voting rights. We
show how, when financial markets are opaque, empty voting and
hidden ownership can render financial markets unpredictable,
unstable, and inefficient. By contrast, we show that when financial
markets are transparent, empty voting and hidden ownership have
dramatically different effects. They cause financial markets to
follow predictable patterns, encourage stable outcomes, and can
improve efficiency. Our analysis lends insight into the operation
of securities markets in general and derivatives markets in
particular. It provides a new justification for a robust mandatory
disclosure regime and facilitates analysis of proposed substantive
securities regulations.
TABLE OF CONTENTS
I. INTRODUCTION ............................................................................ 3
II. THE CLASSICAL THEORY AND THE MODERN WORLD ................. 9
A. The Classical Theory ........................................................... 9
B. Decoupling and Derivatives: The Small Picture ............... 11
C. Decoupling and Derivatives: The Big Picture ................... 15
D. The Problems of Decoupling ............................................. 20
E. The Classical Theory Revisited .......................................... 23
III. COMPETITIVE EQUILIBRIUM AND THE CHALLENGE OF
CONTROL ............................................................................ 26
A. Competitive Equilibrium Generally ................................... 26
B. Competitive Equilibrium with Control Rights ................... 28
C. Competitive Equilibrium with Transferable Control
Rights.............................................................................. 35
IV. THE CORE OUTCOME ............................................................... 37
A. Existence ............................................................................ 38
B. Efficiency............................................................................ 41
C. Voluntariness and Stability ................................................ 41
D. Reasonableness .................................................................. 44
E. Predictive Power ................................................................ 44
V. IMPLICATIONS OF THE CORE OUTCOME FRAMEWORK............... 48
A. Implications of the Growth of Derivatives Markets and
Decoupling .................................................................... 48
B. Implications for Securities Regulation Policy ................... 53
1. Disclosure Rules ............................................................. 53
2. Substantive Intervention ................................................. 58
C. Relaxing Simplifying Assumptions ..................................... 60
1. Transaction Costs ........................................................... 60
2. Information ..................................................................... 62
VI. CONCLUSION ........................................................................... 64

I. INTRODUCTION
In late 2005, Henderson Land made an offer to acquire all
outstanding shares of Henderson Investments, its partially owned
subsidiary, for a substantial premium.1 Henderson Investments
minority shareholders reacted favorably.2
The transaction
3
appeared highly likely to be consummated, and the market price
of Henderson Investments shares rose 44% in response.4
However, in January 2006, market watchers were surprised
to discover that Henderson Investments minority shareholders had
cast enough votes against the deal to prevent it from happening.5
According to reports, a lone hedge fund surreptitiously acquired
enough Henderson Investments shares to block the transaction.6
But what took this development from merely surprising to
outright troubling was that this same hedge fund had also placed
large bets that the price of Henderson Investments shares would
drop.7 As a result, even though this hedge fund held a significant
percentage of Henderson Investments shares, it stood to profit if
Henderson Investments decreased in value. In other words, the
hedge fund voted to block the takeover because the takeover was

The exact offer was a share swap, in which shareholders of Henderson

Investments could exchange 2.5 shares of Henderson Investments for 1 share of
Henderson Land. Business BriefHenderson Land Development Co.: Bid Is
Sweetened for Proposal to Take Investment Unit Private, WALL ST. J., Dec. 13,
2005. We are grateful to Henry T.C. Hu and Bernard Black for unearthing this
example, as well as many others that we discuss in this paper. See Henry T.C.
Hu & Bernard Black, Equity and Debt Decoupling and Empty Voting II:
Importance and Extensions, 156 U. PA. L. REV. 625, 661 tbl.1 (2008).
2
Florian Gimbel & Francesco Guerrera, Henderson Stock Lending Fears
Unusually Heavy Volumes of Borrowed Shares Ahead of Decisive VoteCritics
Claim the Practice Is a Form of Market Abuse, FIN. TIMES ASIA, Feb. 15, 2006,
at 15.
3
Id.
4
Compare Jonathan Li, UPDATE: HK Henderson Investments Holders Reject
2nd Buyout Bid, DOW JONES NEWSWIRE, Jan. 20, 2006, with Henderson
Investments Ltd., Joint AnnouncementProposed Privatisation of the Company
by Henderson Land Development Company Limited (HLD) by way of a
Scheme of Arrangement (the Privatisation Proposal) (Supplemental) (Nov. 18,
2005).
5
Hong Kong Shares Fall 0.1 Percent, But China-Related Issues Continue To Do
Well, ASSOC. PRESS FIN. WIRE, Jan. 20, 2006.
6
Alex F. McMillian, Hong Kong Studying Voting Issues on Borrowed Shares,
INFOVEST21 NEWS, Jan. 25, 2006.
7
See id.

good for Henderson Investments and the hedge fund wanted to

make Henderson Investments less valuable.
This incident is an example of empty voting.8 Empty
voting arises when an actors voting interest in a corporation is
larger than her economic interest.9 It is an instance of a larger
phenomenon, known as decoupling, in which the legal control
rights and the economic ownership rights that accompany share
ownership are separated from each other. Decoupling raises a host
of issues because it turns the conventional logic for granting
shareholders voting rightstheir economic interest in the
corporationon its head.
Most decoupling incidents have involved the use of
financial derivatives,10 and the explosive growth of these financial
derivatives has spurred a surge in empty voting and other
decoupling behavior.11
Decoupling incidents have cast a
tremendous shadow over world financial markets: They have
produced front-page headlines,12 produced cloak-and-dagger
clandestine corporate takeover attempts,13 and led to the ousters of
CEOs at major banks.14

See Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and
Hidden (Morphable) Ownership, 79 S. CAL. L. REV. 811, 815 (2006); see also
Shaun Martin & Frank Partnoy, Encumbered Shares, 2005 U. ILL. L. REV. 775,
787-804 (2005) (referring to this phenomenon as encumbered shares).
9
Hu & Black, supra note 8, at 815.
10
Derivatives are securities whose value depends on (i.e., is derived from) other
securities. FRANK PARTNOY, F.I.A.S.C.O.: BLOOD IN THE WATER ON WALL
STREET 27 (1997). For more detailed discussion and examples, see Part II.BC,
infra.
11
See Hu & Black, supra note 1, at 629, 661 tbl.1; see also Part II.BC, infra.
12
See, e.g., Simon Targett, Top Pension Funds Plan Security Lending Code,
FIN. TIMES (LONDON), June 14, 2004, at 1; John Waples, Ritblat Hits at CSFB
and Laxey for Vote Conspiracy, FIN. TIMES (LONDON), July 21, 2002 at 1.
13
See, e.g., Katharina Bart, Backlash for Swiss BankPoliticians Consider ZKB
Privatization Amid Options Dispute, WALL ST. J., Sept. 18, 2007; Haig
Simonian, Victory Jitters Strike Swiss IndustrialistsLoopholes in Disclosure
Rules Allow Austrian Corporate Raider To Build Large Stakes in Its Targets by
Stealth, FIN. TIMES, Mar. 19, 2007, at 24; Swiss Reinsurer Rejects Takeover Bid
by French, INTL HERALD TRIB., Feb. 20, 2007; Adam Jones & Haig Simonian,
Converium Accepts New Scor Bid, FIN. TIMES, May 11, 2007 at 17.
14
See, e.g., Haig Simonian, ZKB Head Quits in Row on Disclosure, FIN. TIMES,
May 8, 2007, at 24. They have also led to police raids. See, e.g., ZKB, Deutsche
Offices Raided by Swiss Watchdog, REUTERS, May 24, 2007, available at
http://www.reuters.com/article/2007/05/24/idUSL2463554520070524.

Regulators from numerous jurisdictions, including the

United States,15 Canada,16 the United Kingdom,17 Switzerland,18
Hong Kong,19 Australia,20 Italy,21 and the Netherlands,22 have
scrambled to respond to the growing wave of decoupling
transactions. Unfortunately, these responses have largely been
reactive measures taken in response to specific incidents.23

15

See, e.g., Order Approving Proposed NYSE Rule 452, Release No. 34-60215,
File
No.
SR-NYSE-2006-92
(July
1,
2009),
available
at
http://www.sec.gov/rules/sro/nyse/2010/34-62874.pdf
(restricting
brokers
ability to vote shares they do not beneficially own) ; Press Release, CtW
Investment Group, CtW Investment Group Commends the SEC for Approving
Changes to Broker Vote Rule in Director Elections (July 1, 2009), available at
SONSINI
http://www.ctwinvestmentgroup.com/index.php?id=119;
WILSON
GOODRICH & ROSATI, 2009 PROXY SEASON UPDATE, Apr. 16, 2009,
http://www.wsgr.com/wsgr/Display.aspx?SectionName=publications/PDFSearc
h/wsgralert_proxy_season.htm (Institutional investors have urged the SEC to
adopt the proposed amendment, citing . . . the CVS Caremark 2007 director
election and Washington Mutual 2008 director election . . . .).
16
See, e.g., Janet McFarland, Hedge Funds Praise OSC Ruling on Sears, THE
GLOBE AND MAIL (CANADA), Sept. 15, 2006.
17
See, e.g., WEIL, GOTSHAL & MANGES, WEIL BRIEFING: UK TAKEOVERS (Mar.
2010), www.weil.com/files/Publication/ (discussing new disclosure rules for
cash-settled derivatives and other changes to the UKs disclosure regime).
18
See, e.g., Alexander Vogel & Andrea Sieber, Meyerlustenberger Lachenal,
Disclosure
Rules
in
Switzerland:
Recent
Developments,
US.PRACTICALLAW.COM/ (discussing 2007 and 2011 amendments expanding
Swiss disclosure laws in response to decoupling incidents); Dieter Gericke &
Emanuel Dettwiler, Homburger, Disclosure of Shareholdings: Tightened
Requirements,
HOMBURGER
BULLETIN
(Nov.
30,
2007),
homburger.ch/fileadmin/publications/HBDISCSH_01.pdf (discussing 2007
amendments).
19
See, e.g., SLAUGHTER AND MAY, A GUIDE TO THE SECURITIES AND FUTURES
ORDINANCE 17-19 (Apr. 2003), www.slaughterandmay.com/media/ (discussing
new Hong Kong regulatory rules requiring increased disclosure of derivatives
positions); William Mackesy, Deacons, Hong Kong: Disclosure of Interests in
Securities of Hong Kong Listed Companies: SFC Consultation Conclusions,
HG.ORG, Oct. 24, 2005, www.hg.org/articles/article_850.html (discussing
further expansions enacted in 2005)
20
See, e.g., Glencore Intl AG v Takeovers Panel (2006) 151 F.C.R. 277
(reviewing the Australian takeover panels response to Glencores decoupling
behavior); Corporations Amendment (Takeovers) Act, 2007, No. 64, 2007
(Austl.) (changing the law in response to the courts ruling).
21
See, e.g., Italys Consob Rules IFIL Not Obliged to Bid for Fiat, But Swap
Deal Probed, AFX NEWS, FEB. 8, 2006 (discussing a decoupling incident that
sparked investigations by Italys securities regulator and Italian prosecutors).
22
See, e.g., Jan Willem Van der Staay, Public Takeovers in the Netherlands,
CORP. FIN., Jan. 1, 2000, at 83 (discussing decoupling incidents and Dutch
regulators responses).
23
See, e.g., Order Approving Proposed NYSE Rule 452, supra note 15
(responding to incidents at Caremark and Washington Mutual); Corporations
Amendment (Takeovers) Act, 2007, No. 64, 2007 (Austl.) (changing Australian

A more proactive response to decoupling would be

desirable, but one must be careful not to throw the baby out with
the bathwater: although some decoupling incidents are quite
troubling, there are many instances in which decoupling is socially
beneficial. For example, if managers misbehave, observant
shareholders can use decoupling strategies to acquire additional
voting interests more cheaply than would otherwise be possible.24
These shareholders can then use their additional (empty) voting
power to pressure management to improve their behavior.25 Other
examples abound.26
Thus, for regulators to respond to decoupling appropriately,
they need a framework that allows them to predict when
decoupling will be good for society and when it will be
detrimental. The framework that economists typically use to
analyze markets and how those markets will react to changes in
legal rules or other factors, is based on a concept known as
competitive equilibrium. Competitive equilibrium chiefly focuses
on prices. The heart of the competitive equilibrium framework is
the notion that, if each actor acts to maximize her own well-being,
there is a set of prices at which the market will clear. In other
words, at the prices in question, everyone who wishes to purchase
or sell items may do so.
As we show in this Article, the competitive equilibrium
framework breaks down when applied to markets that include
choices beyond the decision to buy or sell goods. For example,
corporate shareholders decide, by vote, which directors to elect and
whether to approve certain corporate actions. We term the right to
make such non-purchase decisions control rights. As we will
demonstrate, once control rights are introduced into a market,
competitive equilibria lose their normative appeal and may fail to
exist altogether. This problem gets much worse when control
rights with respect to a corporation can be bought and sold
independently of economic interests in that corporation. When
corporate ownership and control can be fully decoupledas
securities law in response to a decoupling incident involving Glencore and
Austral Coal).
24
See, e.g., Laxey Gets Digging in Switzerland, FT.COM, Nov. 2, 2007 at 9:26,
ftalphaville.ft.com/blog/2007/11/02/8581/laxey-gets-digging-in-switzerland.
25
See id.
26
See discussion in Part II.E, infra.

modern derivatives markets increasingly ensurecompetitive

equilibria essentially never exist.
Our results offer insight into the implications of sizable
derivatives markets. The prevailing view among many economists
is that derivatives markets simply enable the markets for other
securities to incorporate information better and faster. Under this
view, increasing the size of derivatives markets can only increase
the efficiency of financial markets.
Our formal analysis contradicts this view. We illustrate
how large derivative markets can make financial markets
unpredictable, unstable, and inefficient. Thus, large derivatives
markets can have major and, potentially (but not exclusively),
negative consequences for financial markets.
As an alternative to the concept of competitive equilibria,
we propose a different concept, which we term the core
outcome.27 The hallmark of a core outcome is that no group of
actors can change their behavior in a way that makes the group as a
whole better off.28 We demonstrate that core outcomes have
numerous attractive properties that make the core outcome
framework well-suited for analyzing markets that include control
rights: In contrast to competitive equilibria, core outcomes always
exist and are always efficient. Core outcomes can always be
achieved through voluntary trading among self-interested actors.
Core outcomes are stable; once the market reaches a core outcome,
no group of actors has both the capability and the desire to move
the market to a different outcome. The core outcome framework
enables us to predict how all significant control rights will be
exercised.29 Finally, the core outcome framework predicts what
types of portfolios actors will hold. These predicted portfolios
closely resemble the diversified portfolios that most investors hold
27

This concept is adapted from a concept in cooperative game theory known as

the core. See ROGER B. MYERSON, GAME THEORY: ANALYSIS OF CONFLICT
417-482 (1991).
28
This is equivalent to showing that there is no way to make every group
member better off. Essentially, if the groups winners gain more than its losers
lose, they could (over-)compensate the losers for their losses and remain
winners. See APPENDIX, infra note 33, at 1.2.
29
This will not be true if there are different decisions that give the same social
utility, but it is unlikely that this would be the case with respect to any two
significant decisions.

in the real world.30 Even when ownership and control are fully
decoupled, all of these features persist.
We show that knowledge of all major market participants
economic and control rights is both sufficient and essential for
achieving a core outcome.31 When this information is widely
available, our model suggests that decoupling should occur only in
those situations in which it is socially beneficial, and not in more
troubling cases such as the Henderson Investments incident
described above. However, private parties left to their own devices
will generally not have the proper incentives to ensure that this
information is provided to the market. Our analysis therefore
provides a strong justification for a comprehensive, effective
mandatory disclosure regime for securities markets, including
derivatives markets.32
Finally, the core outcome framework also allows us to
evaluate substantive regulatory interventions that have been
proposed to address decoupling. It supports some of these
interventions, and counsels caution with respect to others. It
suggests that substantive rules to address decoupling may be
particularly useful when disclosure is imperfect and when other
regulations effectively align individual firms interests with the
larger social good.
Part II of this Article provides the necessary background on
decoupling. It begins by explaining how derivatives enable
investors to separate economic and voting interests. It then
discusses how rapid derivatives market growth has fueled
decoupling behavior, undermining the traditional justification for
shareholders control rights and challenging securities regulators.
Part III explains the concept of competitive equilibrium and
catalogs its failings in the context of markets with control rights. It
30

See, e.g., William N. Goetzmann & Alok Kumar, Equity Portfolio

Diversification, 12 REV. FIN. 433, 435-38 (2008) (discussing portfolio
diversification by U.S. investors).
31
See APPENDIX, infra note 33, at 1.2.
32
The lack of disclosure and the opacity of many decoupling transactions has
also been a significant problem for regulators, who have struggled to get a clear
picture of how different actors currently employ decoupling strategies in the
marketplace. See, e.g., EUROPEAN SECURITIES AND MARKET AUTHORITY, CALL
FOR EVIDENCE ON EMPTY VOTING (Sept 14., 2011), available at
esma.europa.eu/consultation/ (asking market participants to provide information
about empty voting incidents).

also illustrates how derivatives markets greatly exacerbate these

failings. Part IV presents the core outcome, which we propose as
an alternative to the competitive equilibrium, and demonstrates its
key properties. Part V explores the policy implications of the core
outcome analytical framework for several areas of interest,
including derivatives markets and securities regulation.
Throughout the Article, we include citations to a mathematical
appendix that contains formal proofs of our results.33
II. THE CLASSICAL THEORY AND THE MODERN WORLD
A. The Classical Theory
The interests of shareholders are central to U.S. corporate
law. Corporate managers generally have fiduciary duties to
shareholders,34 and only to shareholders.35 Managers are overseen
by the corporations board of directors,36 which is elected by the
corporations shareholders37 and is thus accountable to them.38
Like managers, directors are legally obligated to further
shareholders interests.39 In addition, certain major corporate
actions, such as liquidations,40 large asset sales,41 and mergers42
must be approved by the shareholders directly.
It is not immediately obvious why shareholder interests
deserve so much attention.43 Shareholders are not the only parties
affected by the corporations activities; its choices can have serious

33

See JORDAN M. BARRY ET AL., MATHEMATICAL APPENDIX, at faculty-gsb.

stanford.edu/hatfield/documents/EVMathematicalAppendix.pdf
[hereinafter
Appendix].
34
Dodge v. Ford Motor Co., 170 N.W. 668 (Mich. 1919).
35
Id.; see also N.Y. Bus. Corp. Law 717(b); 15 Pa. Cons. Stat. 1717;
STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS 410-17 (2002)
(discussing same).
36
BAINBRIDGE, supra note 35, at 192-93.
37
See, e.g., Del. Code Ann. tit. 8, 211(b) (2011).
38
BAINBRIDGE, supra note 35, at 192-93.
39
Dodge, 170 N.W. at 672.
40
See, e.g., Del. Code Ann. tit. 8, 275(b) (2011).
41
See, e.g., Del Code Ann. tit. 8 271(a) (2011).
42
See, e.g., Del Code Ann. tit. 8 251(c) (2011).
43
See Edwin M. Epstein, The Good Company, Rhetoric or Reality?
Corporate Social Responsibility and Business Ethics Redux, 44 AM. BUS. L.J.
207, 212-13 (2007). Some other countries laws place relatively less importance
on shareholders interests. See Terrence L. Blackburn, The Societas Europea:
The Evolving European Corporation Statute, 61 FORDHAM L. REV. 695, 744-52
(1993).

effects on the welfare of its employees,44 its creditors,45 its

customers,46 and society at large.47 Why should the interests of the
shareholders be paramount?
The classic justification for shareholder control rights, and
their centrality in corporate law more generally, stems from
shareholders economic interest in the corporation. Shareholders,
by virtue of their share ownership, are entitled to whatever profits
remain after the corporation satisfies its other obligations.48 As the
residual claimants of the firms assets,49 they are, in a sense, the
owners of the firm; they ultimately reap the benefits, or bear the
costs, of any change in the firms value.
Accordingly,
shareholders want to maximize the corporations value,50 and
making their interests central encourages managers to do just
that.51 A long line of legal and economic scholarship supports and
reinforces this view.52 This whole theoretical structure rests on the
correspondence between shareholders economic interests and their
voting interests.53

44

BAINBRIDGE, supra note 35, at 466.

See Sudheer Chava et al., Managerial Agency and Bond Covenants, 23 REV.
FIN. STUD. 1120 (2009) (considering how corporate activities affect bondholders
and responses to this dynamic).
46
See Shawn L. Berman et al., Does Stakeholder Orientation Matter? The
Relationship Between Stakeholder Management Models and Firm Financial
Performance, 42 ACAD. MGMT. J. 488, 490 (1999).
47
See E. Merrick Dodd, Jr., For Whom Are Corporate Managers Trustees?, 45
HARV. L. REV. 1145 (1932); E. Merrick Dodd, Jr., Is Effective Enforcement of
the Fiduciary Duties of Corporate Managers Practicable?, 2 U. CHI. L. REV.
194 (1935).
48
BAINBRIDGE, supra note 35, at 469-70; FRANK H. EASTERBROOK & DANIEL R.
FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 66-72 (1991).
49
This assumes that the corporation is not in bankruptcy. In such instances, the
creditors interests become paramount. BAINBRIDGE, supra note 35, at 431.
50
BAINBRIDGE, supra note 35, at 469 n.16.
51
Some have questioned whether it would be better to prioritize only the
interests of some shareholders, such as long-term owners. See, e.g., Lynne
Dallas, Short-Termism, the Financial Crisis, and Corporate Governance, 37 J.
CORP. L. 264 (2011).
52
See, e.g., Bernard Black & Reinier Kraakman, A Self-Enforcing Model of
Corporate Law, 109 HARV. L. REV. 1911, 1945-46 (1996); Frank H.
Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J.L. & ECON. 395
(1983); Sanford J. Grossman & Oliver D. Hart, One Share-One Vote and the
Market for Corporate Control, 20 J. FIN. ECON. 175 (1988); Milton Harris &
Artur Raviv, Corporate Governance: Voting Rights and Majority Rules, 20 J.
FIN. ECON. 203 (1988).
53
See Martin & Partnoy, supra note 8, at 788.
45

10

B. Decoupling and Derivatives: The Small Picture

However, in the last few decades there has been a quiet but
dramatic increase in the frequency with which shareholders hold
economic interests and control interests of differing sizes.
Economic ownership and control rights have become increasingly
decoupled from each other. This trend has been driven by rapid
growth in derivatives markets.
A derivative is a security whose value derives from the
value of another security or securities.54 This abstract concept can
be easily understood through a simple example. Consider a
contract that provides for the sale of a specified quantity of
somethinga bag of potatoes, a barrel of wheat, a ton of coal,
etc.at a particular price on a set day in the future. Such a
contract is known as a futures contract55 and the item being sold is
termed the underlying asset, or simply the underlying.56 The value
of the futures contract depends on the value of the underlying.57 If
the underlying is a securitysuch as a share of Microsoft stock
then the futures contract is a derivative.58
For example, consider a futures contract that provided for
the sale of one share of Microsoft stock three months from now at
a sale price of $10. Since Microsoft stock trades freely in public
markets, the value of that futures contract depends on the value of
Microsoft stock. Three months from now, if shares of Microsoft
stock are being bought and sold for $14, a contract to buy a share
for only $10 is a valuable asset. The stock purchaser would pay
$10 for stock that she could immediately sell for $14. On the other
hand, if Microsoft stock is trading at $6 per share, the obligation to
buy at $10 is a costly liability.59 The stock purchaser would be

54

PARTNOY, supra note 10, at 27 (1997). This second security is known as the
underlying.
55
Depending on the specifics, such a contract may be a similar derivative known
as a forward contract. The differences between forward and futures contracts
are generally irrelevant for our purposes. We refer to such contracts as futures
contracts because we believe that readers often find that terminology more
intuitive.
56
See Underlying Asset, INVESTOPEDIA.COM, investopedia.com/terms/u/
underlying-asset.asp.
57
Id.
58
Id.
59
Or, alternatively, the right to sell Microsoft at $10 is quite valuable.

11

paying $10 for something that she could easily buy for only $6.60
Thus, the value of the futures contract depends on the value of
Microsoft stock; the futures contracts value derives from
Microsoft stocks value.
Now suppose that Alice has ten shares of Microsoft stock,
currently worth a total of $100. Alice then enters into a futures
contract with Bob. Pursuant to that contract, Bob agrees to buy ten
shares of Microsoft stock from Alice in three months for a total
price of $100. Consider what happens to Alice if the price of
Microsoft stock increases from $10 a share to $20 a share. Her
Microsoft holdings will become more valuable; their worth will
increase from $100 to $200. However, Alice will not benefit;
pursuant to the terms of their contract, she will still have to sell her
shares to Bob for $100. Similarly, if the price of Microsoft shares
drops from $10 to $5, Alice will not be hurt because she will still
get to sell her shares to Bob for $100. As long as Alice and Bob
honor their contract, Alice has no economic interest in Microsoft
stock and she will not care what happens to Microsofts value.
But while Alice has no economic interest in her ten
Microsoft shares, she remains the legal owner of those shares for
the next three months. Until then, she retains all legal rights of
share ownership, including the right to vote those shares. Because
Alices vote is detached from any economic interest in Microsoft
stock, she does not care about Microsofts value; her vote is truly
empty.
Moreover, Alice can enter into a futures contract with Bob
even if she does not own ten shares of Microsoft stock. From the
sellers perspective, a futures contract is just an obligation to
deliver the underlying security at some specified point in the
future. So long as the seller acquires that security before she is
obligated to deliver it to the buyer, all will be well. In such a
scenario, the seller is not indifferent to price changes in the
underlying security, as Alice was above. In these circumstances,
the seller has a negative economic interest; she actively wants the
security to decrease in value.

60

Equivalently, she must pay $10 for something that has an objective value of
only $6.

12

The logic behind this result is that, in order to meet her

obligations under the futures contract, the seller must deliver the
underlying security to the buyer. To do that, she herself must first
acquire the underlying security, which generally means going out
into the market and purchasing that security. Thus, the cost to the
seller of fulfilling the contract is the market price of the underlying
security.61 Accordingly, the lower the underlying securitys
market price, the less it will cost the seller to fulfill her obligations
and the better off she will be.62
An example helps illustrate this point.63 Suppose that Alice
initially owns five shares of Microsoft stock, each worth $10, and
agrees to sell Bob ten shares of Microsoft stock in three months,
for $100. If the value of a share of Microsoft stock increases from
$10 to $15, the value of Alices original five shares of Microsoft
stock increases from $50 to $75, a gain of $25. However, the
value of the shares that Alice must deliver to Bob under the futures
contract increases from $100 to $150, a gain of $50. Since Alices
obligations under the contract have increased by $50 while the
value of her holdings has only increased by $25, she is $25 worse
off.
On the other hand, consider Alices position if the value of
a share of Microsoft stock declines to $5. The five Microsoft
shares that Alice owns will drop in value from $50 to $25, a loss of
$25. However, the value of the shares that Alice must deliver
under her contract with Bob will drop from $100 to $50. Thus,
Alice is now better off; although the value of her holdings
decreased by $25, the cost of fulfilling her contractual obligations
to Bob decreased by an even larger amount ($50).
This example demonstrates how, even though Alice is a
Microsoft shareholder, she now has a negative economic interest in
61

This is true even if the seller already owns the security, because, absent her
contractual obligation to give the security to the buyer, the seller could sell that
security for its market price.
Cf. HAL R. VARIAN, INTERMEDIATE
MICROECONOMICS: A MODERN APPROACH 318 (4th ed. 1996) (discussing
opportunity cost).
62
For cash-settled futures contracts, the payment that the seller receives from the
buyer increases as the value of the security decreases. Thus, the sellers
economic interest is the same in both cases. See Part II.C, infra.
63
This example assumes that the futures contract is settled in kind, but the
analysis is analogous for a cash-settled futures contract. See Part II.C, infra.

13

Microsoft. In other words, Alice actively hopes that the shares will
drop in value. Despite this, Alice still owns Microsoft shares, and
remains entitled to vote in Microsofts corporate elections. Given
Alices incentives, she should consistently vote against Microsofts
intereststo the chagrin of Microsofts other shareholders.64
When an actors control rights exceed her economic rights,
such as Alices do in the examples above, that actor is termed an
empty voter.65 Similarly, the act of exercising those control rights
is referred to as empty voting.66 Empty voting derives its name
from the fact that, because the voter has less of an economic stake
in the corporationshe has less skin in the game, so to speak
her vote has been emptied of the economic consequences it might
have for her.67
Thus far we have focused on Alice; what of Bobs
position? Once the futures contract is made, Bob has an economic
interest in Microsoft shares, but not a voting interest: Under the
terms of the contract, he will receive Microsoft shares.68 In either
instance, if the value of Microsoft changes, Bob will reap the
benefit or bear the loss. But, until the end of the contract, Bob will
not actually own any shares in Microsoft.69 Thus, in counterpoint
to Alice, Bobs economic interest in Microsoft stock exceeds his
voting interest.
When a persons economic rights exceed his control rights,
such as Bobs do in the examples above, it is referred to as hidden
ownership.70 Public disclosures by key actors, such as large
shareholders,71 institutional investors,72 and corporate insiders73 are
64

Cf. BAINBRIDGE, supra note 35, at 469 n.16 (noting that shareholders
generally share the desire to maximize firm value).
65
Hu & Black, supra note 8, at 815; see also Martin & Partnoy, supra note 8, at
780 (using the term encumbered shares).
66
Hu & Black, supra note 8, at 815.
67
Id. To be clear, it may not be emptied of all of its economic consequences.
Alternatively, if she has a negative economic interest in the corporation, her vote
still holds economic consequences, but they run in the opposite direction of what
one would ordinarily expect.
68
If the contract is cash-settled, he may receive a cash payment of equal value.
See Part II.C, infra.
69
If the contract is cash-settled, Bob may never own any Microsoft shares. See
Part II.C, infra.
70
Hu & Black, supra note 8, at 815.
71
See, e.g., SECURITIES AND EXCHANGE COMMN, SCHEDULE 13D, available at
secfile.net/forms/sched13d.pdf (for investors who own 5% or more of a class of

14

fundamental to modern securities laws worldwide.74 However,

many of these disclosure obligations are triggered by actors
amassing a particular degree of voting power.75 Accordingly,
economic interests such as Bobs often do not trigger disclosure
obligations and thus are hidden from public view.
If a hidden owner can easily acquire or control a voting
interest proportional to his economic interest, then his interest is
also morphable, as it may morph into an interest with both
economic and voting rights.76 For example, suppose Bob and
Alice enter into a futures contract under which Bob will purchase
all of Alices Microsoft shares for a particular price on a particular
date. Alice informally agrees that, until the transaction closes, she
will vote the shares in accordance with Bobs preferences.77 Bobs
position would constitute hidden and morphable ownership.78
C. Decoupling and Derivatives: The Big Picture
The examples above provide clear illustrations of how
economic and control rights may be decoupled, but they are by no
means the only ways. Modern finance offers a multitude of ways
for an investor to hold divergent interests with respect to the
economics and control of a corporation: She can engage in short
registered equities with voting rights); SECURITIES AND EXCHANGE COMMN,
SCHEDULE 13G, available at secfile.net/forms/sched13g.pdf (abbreviated
disclosure form for similar).
72
See, e.g., SECURITIES AND EXCHANGE COMMN, FORM 13F, available at
sec.gov/about/forms/form13f.pdf (for institutional investment managers with
$100 million or more in specified assets under management).
73
See, e.g., Robert A. Friedel & Andrew L. Romberger, Pepper Hamilton LLP,
Expedited Disclosure of Insider Trnsactions Under Section 16, CORPORATE AND
SECURITIES LAW UPDATE (Aug. 28, 2002), available at pepperlaw.com
(discussing disclosure rules applicable to directors, executive officers, and other
insiders).
74
See Stephen Bainbridge, Mandatory Disclosure and Securities Regulation: A
Behavioral Analysis, PROFESSORBAINBRIDGE.COM, Jan. 29, 2010 (Mandatory
disclosure is amaybe thedefining characteristic of U.S. securities
regulation.).
75
Cf. Hu & Black, supra note 8, at 866 tbl.3 (illustrating the different interests
that trigger filing obligations under various U.S. disclosure laws).
76
Id. at 815-16.
77
Note that Alice would be likely to agree to this because she has no economic
interest in Microsoft. She therefore only cares about votes by Microsoft
shareholders to the extent they affect other interests she may have. See notes
104105, infra and accompanying text.
78
Hu & Black, supra note 8, at 815-16. Note that Alice would be an empty
voter. Id.

15

sales.79 She could purchase or sell call or put options on the

companys stock.80 She could purchase or sell credit default swaps
on the companys debt.81 The list goes on.82 These scenarios vary
significantly,83 but they all arise through the use of derivatives.84
For many years, the derivatives market was quite small
compared to the public market for stocks. As a result, it was
generally too expensive for major shareholders to acquire
derivatives positions sizable enough to enable large-scale
decoupling.85 However, over the past few decades, the size of
derivative markets has grown explosively.86 This has made
decoupling an increasingly common problem.
79

An investor who sells short borrows a security, then sells it. The investor later
purchases an identical security to give back to the lender. The investor profits if
the price of the security drops after she sells it. See Short Selling,
INVESTOPEDIA.COM.
80
The buyer of a call (put) option receives the right, but not the obligation, to
buy (sell) a specified quantity of another security on a particular date at a
specified price, known as the strike price. If the strike price is lower (higher)
than the market price for the underlying security, the option can be quite
valuable. Fischer Black & Myron Scholes, The Pricing of Options and
Corporate Liabilities, 81 J. POL. ECON. 637 (1973); see also Martin & Partnoy,
supra note 8, at 789.
81
The buyer of a credit default swap receives a payment from the seller if a
particular borrower fails to make payments on a specified debt obligation. It
resembles an insurance policy against default by the borrower. Since buyers
only receive payment if the borrower defaults, the value of the credit default
swap closely (and inversely) depends on the value of the borrowers debt and
equity. See FRANK PARTNOY, INFECTIOUS GREED: HOW DECEIT AND RISK
CORRUPTED THE FINANCIAL MARKETS 372-73 (2009).
82
See Martin & Partnoy, supra note 8, at 789-92 (collecting examples).
83
See id. (discussing the incentives of shareholders with varied derivatives
holdings).
84
To be clear, we do not mean to imply that similar decoupling scenarios cannot
arise without the use of derivatives. See Joseph Bankman & Ian Ayres,
Substitutes For Insider Trading, Stanford Law and Economics Olin Working
Paper No.214, Yale Law and Economics Research Paper No. 252 (April 2001),
available at ssrn.com (discussing connections between certain firms securities
that investors can utilize); Hu & Black, supra note 8, at 844-45 (similar). Our
point is simply that derivatives offer many opportunities for decoupling. They
make decoupling far cheaper and easier to accomplish, and therefore much more
likely to take place. Even decoupling strategies that do not require derivatives
such as a shareholder acquiring a large stake in the stock of a competitor whose
shares increase in value whenever the first companys value decreasesare
much easier and cheaper to execute by using derivatives. Id. at 844-45.
85
Cf. PARTNOY, supra note 81, at 250-54 (discussing the difficulty of finding
counterparties for sufficiently large derivatives transactions).
86
Derivatives often allow parties to hedge risk at lower cost than would
otherwise be possible. They also can allow parties to speculate or avoid
regulations or taxes. The relative size of these motivators in growing the market

16

For example, take 1985, the year that the swaps and
derivatives dealers formed ISDA,87 their industry trade
association.88 At that time, the size of the swaps market was
estimated to be approximately $100 billion.89 While clearly
considerable, this paled in comparison to the $2.1 trillion U.S.
market for public traded equities.90
Since then, derivatives markets have become so large that it
is difficult to conceptualize how big they are.91 In June 2011, the
size of the global derivatives market was estimated at over $700
trillion.92 This is approximately a dozen times larger than the peak
equity value of all publicly traded companies in the world.93 This
is nearly 50 times the economic output of the United States94and
almost nine times the economic output of the entire worldthat
year.95
The tremendous growth of derivatives markets has led to a
surge in decoupling incidents. Professors Hu and Black, who have
been at the forefront of decoupling scholarship, have catalogued
significant decoupling incidents stretching back over two
decades.96 They found five times as many examples from 2000
is a matter of debate. See id. at 4-5; Victor Fleischer, Regulatory Arbitrage, 89
TEX. L. REV. 227, 229-30. (2010-2011).
87
ISDA stands for the International Swaps Dealers Association. PARTNOY,
supra note 81, at 45.
88
Id.
89
Id. The numbers quoted herein are notional amounts, which is, roughly, the
amount of money at stake in the contract. Typically, this will be much larger
than the amount of money that changes hands in the course of the contract. See
id. at 148-49.
90
This number comes from the USDVAL variable in the CRSP database for
December 31, 1985.
91
To be clear, much of the derivatives market is not directly related to corporate
equities or debt. See PARTNOY, supra note 81, at 3-5. Nonetheless, the point
remains that markets for derivatives, including those related to firms, have
become much larger.
92
BANK FOR INTERNATIONAL SETTLEMENTS, OTC DERIVATIVES MARKET
ACTIVITY IN THE FIRST HALF OF 2011 (Nov. 2011), available at
www.bis.org/publ/otc_hy1111.pdf.
93
WORLD FEDERATION OF EXCHANGES, 2010 WFE MARKET HIGHLIGHTS
(2011), available at world-exchanges.org/focus/.
94
Statista.com, United States Annual GDP 1990-2011, www.statista.com/
statistics/188105/annual-gdp-of-the-united-states-since-1990/ (identifying U.S.
GDP as $15.094 trillion).
95
CENTRAL INTELLIGENCE AGENCY, WORLD FACTBOOK (2012), available at
cia.gov/library/publications/the-world-factbook/ (identifying 2011 world GDP
as $78.95 trillion).
96
See Hu & Black, supra note 1, at 661 tbl.1 (collecting examples).

17

2003 as from 19951999,97 and fifteen times as many from 2004

2006.98 Since derivatives markets show few signs of slowing their
growth,99 let alone shrinking, decoupling seems likely to be an
increasingly frequent and important occurrence.
There are two additional features of derivatives markets
that increase decoupling and which deserve special mention. First,
most derivatives are entered into over the counter. In other
words, an investor who wants to acquire a derivative position goes
to an investment bank or similar entity and privately negotiates a
contract. The investment bank itself generally does not want the
risk that comes with the contract they have entered into; usually,
the banks goal is simply to earn a profit by charging the investor a
fee to enter into the transaction. Thus, the bank typically finds a
way to hedge its risk under the contract. These hedging
transactions frequently render the investor a hidden and morphable
owner and the bank an empty voter.
For example, suppose that an investor wants to enter into a
derivative that gives her the same opportunity to profit as owning
Microsoft stock.100 Essentially, the bank would make payments to
the investor whenever Microsoft issues a dividend or its stock
increases in value.101 To eliminate this liability, the bank might
purchase shares of Microsoft stock. Then, if Microsoft stock
increases in value, the banks obligation to make payments to the
investor will be completely offset by the increase in the value of
the banks Microsoft stock.102 Similarly, any losses the bank
would experience from a drop in the value of Microsoft stock will

97

See id.
See id.
99
In the first half of 2011, it grew by an estimated 18%. BANK FOR
INTERNATIONAL SETTLEMENTS, supra note 92, at 1.
100
Such contracts are commonly referred to as swaps or contracts for difference.
These derivatives because sometimes receive more favorable tax treatment or
regulatory treatment than stock does than buying stock directly. Fleischer,
supra note 86, at 247-48.
101
Simultaneously, the investor would make payments to the bank whenever
Microsoft stock decreases in value.
102
If Microsoft stocks value increases by $10, the share of Microsoft stock in
the banks portfolio will be worth $10 more. However, under the swap
agreement, the bank must pay the investor $10. The additional asset and
liability net out to zero.
98

18

be exactly offset by payments that the bank receives from the

investor.103
The bank holds Microsoft shares, which give it control
rights, but it has no economic interest in Microsoft. It is an empty
voter. The investor has an economic interest in Microsoft, but no
control rights, making it a hidden owner. And, since the
investment bank has no economic interest in Microsoft, but does
have an interest in its relationship with its client the investor, the
bank may well be willing to vote its shares according to the
investors wishes.104 Thus, the investors hidden ownership is
likely to be morphable as well.105
This example leads us into the second feature of derivatives
markets. Our previous examples involve the physical exchange of
the underlying securities; at the end of the day,106 Alice must
actually give Bob shares of Microsoft stock. These types of
derivatives are known as physically settled, because the underlying
physically changes hands.
Many derivatives, like the example above, do not fit this
mold. The underlying never changes hands; instead, the parties
simply make cash payments to each other that simulate the
economic effects of buying and selling the underlying. Such
derivatives are termed cash-settled. Because no physical securities
actually change hands, cash-settled futures contracts do not require
either contracting party to ever own the underlying security. All it
takes to create a derivative is for two parties to agree to create it.
This means that there is no upper bound on how large derivative
103

If Microsoft stocks value falls by $10, the investor must pay the bank $10.
However, the banks Microsoft stock will be worth $10 less. Again, the
additional liability and asset cancel out.
104
The bank may have other interests that offset this in particular cases. For
example, Microsoft may also be a client of the bank, and Microsoft management
might want the bank to vote its shares in the opposite way that the investor does.
See BNS Post Says U.S. Hedge Fund Looks to Block Sears Deal, CANADA
STOCKWATCH, Apr. 10, 2006 (describing a similar situation in which Scotiabank
voted in accordance with the interests of its client, Sears Holdings, instead of its
other client, the hedge fund Pershing Square).
105
Alternatively, since the bank has already accomplished its goal of earning
fees from arranging the transaction, it will likely be willing to unwind the
transaction, cancelling the contract and selling its Microsoft shares to the
investor at the market price. Then the investor would be entitled to vote by
virtue of her share ownership.
106
More specifically, three months.

19

markets can become. And as derivative markets grow, decoupling

becomes ever cheaper and more commonplace.
D. The Problems of Decoupling
This growth in decoupling raises several potential
problems. First, recall that the classical theory postulated that
giving shareholders control rights promoted efficient results. This
conclusion was built on the correspondence between shareholders
economic interests and control rights. Under this framework, any
divergence between these interests undermines the standard
justification for shareholder voting. The larger the divergence, the
worse the theory predicts that outcomes will be. A negative
correspondence between economic and voting interests should lead
corporations to actively squander resources and destroy as much
value as possiblea terrible outcome for society.
The direct correspondence between shareholders economic
and control rights is important for a second reason as well.107 As
mentioned previously, disclosure rules are fundamental to modern
securities laws worldwide.108 However, the triggers for these
disclosure obligations vary. Some are based on economic
ownership.109 Others focus on the degree of voting power that an
actor controls.110
Once decoupling is permitted, it becomes much easier for
an investor to structure her holdings in a way that circumvents
regulation.111 This is true with respect to both the ownership
thresholds that trigger public filings112 and with respect to the
107

We assume, in this discussion, that mandatory disclosure of large ownership

stakes is socially beneficial. Some commentators have argued to the contrary.
See Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Targets
Management in Responding to a Tender Offer, 94 HARV. L. REV. 1161 (1981);
Alan Schwartz, Search Theory and the Tender Offer Auction, 2 J.L. ECON. &
ORG. 229 (1986). We revisit this question in Part II.E, infra.
108
See Part II.B, supra.
109
See Hu & Black, supra note 8, at 839-40 (discussing examples from Italy and
Australia).
110
Id. at 836 (discussing examples from New Zealand).
111
See generally Jordan M. Barry, On Regulatory Arbitrage, 89 TEXAS LAW
REVIEW SEE ALSO 69 (2011); Fleischer, supra note 86, at 229.
112
Disclosure regimes sometimes fail to require disclosure for functionally
equivalent holdings. See GPG Bid for Rubicon Hits a Snag, THE DOMINION
POST (WELLINGTON), Sept. 9, 2002 (discussing whether investor Perrys cashsettled derivatives positions triggered disclosure obligations under New Zealand

20

interests that those filings must detail.113 In one instance, a

telecommunications minister allegedly used hidden ownership to
maintain a secret 25% stake in a multibillion-dollar
telecommunications company he was charged with regulating.114
The more that investors can custom-tailor their holdings,
the easier it is for them to exploit any gaps in the regulatory net.
This increases the pressure on regulators to construct a regulatory
net with fewer and smaller gaps.115 Even if regulators succeed,
more investors will be burdened by regulation, which itself has
costs.116
Finally, there is also a potential fairness issue. Anecdotal
evidence surrounding decoupling strategies frequently links these
strategies with hedge funds and extremely wealthy individual
investors.117 Since most investors are not extremely wealthy and
cannot invest in hedge funds, they do not have the same access to
decoupling strategies. This is particularly troubling if decoupling
strategies confer an advantage over other strategies.118
Switzerland recently provided a number of dramatic
examples that illustrate all of these points.119 In 2007, several
investors shocked the market by announcing that they held large
ownership stakes in several major Swiss public companies.120

law); Hu & Black, supra note 8, at 818 (discussing same); id. at 866 tbl.3
(illustrating variance among the interests triggering U.S. disclosure obligations).
113
See Hu & Black, supra note 8, at 866 tbl.3 (illustrating variance among the
interests that must be disclosed under various U.S. disclosure laws).
114
See, e.g., Geoffrey T. Smith, Russian Minister Laundered Money to Buy
Mobile Operator, CELLULAR-NEWS, May 23, 2005; Government Minister May
Be Secret Telecoms Fund Investor, CELLULAR-NEWS, Jan. 29, 2006.
115
See generally Fleischer, supra note 86; Frank Partnoy, Financial Derivatives
and the Costs of Regulatory Arbitrage, 22 J. CORP. L. 211 (1997).
116
See R.H. Coase, The Problem of Social Cost, 3 J.L. & ECON. 1, 18 (1960)
(discussing the costs of regulation).
117
See Hu & Black, supra note 1, at 661 tbl.1 (collecting examples).
118
Presumably, those actors who use decoupling strategies believe them to
confer an advantage or they would not use them.
119
See Hu & Black, supra note 8, at 655-59.
120
These companies included Sulzer AG, a Swiss engineering firm; Ascom, an
electronics company; Unaxis, a technology company; Saurer, a machinery
maker; Implenia, a construction group; and Converium, an insurance company.
In January 2007, before these takeover attempts were announced, these
companies had a combined value of several billion dollars.

21

These previously undisclosed ownership stakes ranged from

20%121 to a jaw-dropping 68%.122
These announcements were so surprising because Swiss
law required public disclosures by any shareholders with a 5% or
larger stake in a Swiss public company.123 At the time, the 5%
threshold counted an investors share ownership as well as certain
derivatives, but not others.124 These acquirers avoided Swiss
securities law disclosure requirements by constructing their
ownership stakes out of derivatives that did not count toward the
5% threshold.125
Who were these various surreptitious acquirers? At the
center of these transactions were a few very wealthy individuals,
their investment vehicles, and a hedge fund.126
These events prompted significant responses from
regulators and market participants. Two large banks, Zurcher
Kantonalbank (ZKB) and Deutsche Bank, were heavily involved in
arranging some of the derivatives that acquirers used to build their
ownership.127 Swiss police raided both banks offices.128 ZKBs

121

Chris Flood, Dexia Hidden Jewel Highlighted, FIN. TIMES, Jan. 19, 2007,
available at ft.com/intl/ (discussing Victory Industrials stake in Ascom).
122
Hu & Black, supra note 8, at 657 (discussing Victory Industrials stake in
Unaxis, later renamed OC Oerlikon).
123
Id. at 655; Federal Act on Stock Exchanges and Securities Trading [SESTA]
(Switz.), Mar. 24, 1995, SR 954.1, art. 20, para. 1.
124
More specifically, they included call options on Swiss corporate stock, but
not cash-settled futures, swaps, or similar derivatives. See Hu & Black, supra
note 8, at 655; Ordinance of the Swiss Federal Banking Commission on Stock
Exchanges and Securities Trading [SESTO-SFBC] (Switz.), Jun. 25, 1997, art.
13, para. 1; Ordinance of the Swiss Financial Market Supervisory Authority on
Stock Exchanges and Securities Trading [SESTO-FINMA] (Switz.), Oct. 25,
2008, art. 15, para 1; Federal Act on Stock Exchanges and Securities Trading
[SESTA], supra note 123, art. 20, para. 2.
125
See Simonian, supra note 13. Many of these transactions were later unwound
so that the acquirer held the shares directly. See discussion in Part II.C, supra.
126
Key players in these various takeover attempts included Viktor Vekselburg, a
billionaire Russian oligarch, and his company Renova (Sulzer); multimillionaires Georg Stumpf and Ronny Pecik, their company Victory Holdings,
and its subsidiaries (Ascom, Saurer, Sulzer, and Unaxis); billionaire Martin
Ebner and his company Patinex (Converium); and hedge fund Laxey Partners
(Unaxis and Implenia). See Carl Mortished, Swiss Investigate Vekselberg Firm
Over Stake-Building in Engineer, THE TIMES (LONDON), April 27, 2007. Jones
& Simonian, supra note 13; Simonian, supra note 13; Waples, supra note 12.
127
See Mortished, supra note 126.

22

CEO and several of its other high-ranking executives resigned or

were fired, and the bank changed its policy with respect to such
transactions.129
Swiss regulators promptly expanded the securities used in
calculating an investors ownership to include a wider range of
derivatives.130 The Swiss Parliament reduced the disclosure
threshold from 5% to 3% and expanded the class of derivatives
that trigger disclosure even further.131 These actions tightened the
regulatory net, making it harder to evade the disclosure regime.
However, commentators have noted that these measures do not
address all gaps.132 And, by requiring more investors to file
disclosures, these changes impose additional recordkeeping costs
on investors as a class, including those who will never attempt a
takeover.
It bears emphasis that Switzerland is one of the worlds
largest financial centers. The market value of traded shares in
Swiss public stock markets is approximately $1.2 trillion.133
Further, Switzerlands securities laws have much in common with
those of other major financial centers, including the United States
and the European Union.134 Similar decoupling episodes can
happen in other placesand increasingly have.135
E. The Classical Theory Revisited
The Swiss experience illustrates decouplings importance.
However, responding to decoupling is complicated by the fact that
128

Carl Mortished, Deutsche's Zurich Offices Raided in Options Inquiry, THE

TIMES (LONDON), May 25, 2007; ZKB, Deutsche Offices Raided by Swiss
Watchdog, supra note 14.
129
Simonian, supra note 13. Note that ZKB did not leave the derivatives
market, it merely agreed that it would not knowingly participate in hostile
takeovers of its clients. Id.
130
See Vogel & Sieber, supra note 18; Gericke & Dettwiler, supra note 18.
131
See Vogel & Sieber, supra note 18; Gericke & Dettwiler, supra note 18.
132
Hu & Black, supra note 1, at 659.
133
CENTRAL INTELLIGENCE AGENCY, supra note 95 (listing the market value of
all publicly traded shares on Swiss markets at $1.229 trillion at the end of 2010).
This puts it well ahead of many larger economies, such as Russia ($1.005
trillion) and Italy ($318 billion). Id.
134
See Mathias M. Siems & Michael C. Schouten, The Evolution of Ownership
Disclosure Rules Across Countries, University of Cambridge Centre for
Business Research Working Paper No. 393 at 11 (Dec. 2009) (discussing
similarities between UK, Swiss, and EU securities laws).
135
See Hu & Black, supra note 1, at 661 tbl.1 (collecting many examples).

23

decoupling is not always bad. The classical theory generally

assumes that, at least on average, maximizing the value of the
corporation is best for society.136 This assumption is often justified
on the ground that the public and private regulatory apparatus give
corporations optimal incentives; that is, laws and contracts address
negative externalities137 and align the corporations incentives with
the social good.138
But, in practice, there are instances in which the course of
action that is best for a corporation is not best for society at large.
In such circumstances, it would be better for society if that
corporations shareholders do not vote for the option that
maximizes the value of the corporation. Empty voting would
facilitate such behavior. In these cases, empty voting would seem
to be an outright social positive. Thus, decoupling may be a good
thing.
For example, suppose that shareholders of widget
manufacturer AcmeCo are considering a takeover offer from rival
widget manufacturer BuyerCo. Assume that BuyerCo is motivated
to pursue the transaction because acquiring AcmeCo will give
BuyerCo a monopoly on widget production. As a monopolist,
BuyerCo will increase its profits by raising widget prices and
reducing widget output.139 Such a transaction generally is not
socially beneficial;140 while BuyerCo (and AcmeCo) shareholders
will reap benefits, widget purchasers will suffer even larger
losses.141

136

See RICHARD POSNER, ECONOMIC ANALYSIS OF LAW 284 (8th ed. 2011).
An externality is a cost or benefit of an activity that accrues to actors who are
not involved in the activity. A positive externality creates a benefit to, and a
negative externality imposes a cost on, actors who are not involved in the
activity. Jordan M. Barry, When Second Comes First: Correcting Patents Poor
Secondary Incentives Through an Optional Patent Purchase System, 2007 WISC.
L. REV. 585, 611 n.3.
138
See POSNER, supra note 136, at 353. An alternative is to assume that
negative externalities are small or nonexistent in a particular context, or that
they are balanced or outweighed by positive externalities. Yet another is to
assume that they are addressed by private contract by the affected parties. See
Coase, supra note 116, at 15.
139
See Barry, supra note 137, at 597-99.
140
There could be an exception if the industry is characterized by efficient
monopoly, see POSNER, supra note 136, at 559-62, but for simplicity we will
assume that this is not the case here.
141
Barry, supra note 137, at 597-99.
137

24

This is precisely the sort of transaction that antitrust

regulators should prevent.142 Yet suppose that they do not. What
will happen? If shareholders make their decision based solely on
whether the transaction is in the best interests of AcmeCo, the
takeover is likely to occur.143 Yet, as discussed previously, this
result is bad for society.
On the other hand, the more empty voting there is at
AcmeCo, the more likely it becomes that the takeover attempt will
fail.144 This is a better result for society; thus, empty voting would
appear to be a good thing in this instance. Similar examples can
easily be constructed around environmental, banking, insurance,
labor, food and drug safety, tax, and many other regulatory
failures, as well as other types of decoupling behavior. Examples
can also be constructed around contracting failures by private
actors, such as imperfect takeover offers, bond covenants, and
corporate governance mechanisms.145
Similarly, hidden ownership can also promote efficient
results in some circumstances. Disclosure requirements are often
criticized for discouraging parties from gathering information
142

POSNER, supra note 136, at 387-89.

The transaction will boost BuyerCos profits, so it should be willing to offer
AcmeCo shareholders a significant premium for their shares to induce their
agreement. Alternatively, BuyerCo could structure the transaction as a sharefor-share deal so that AcmeCo shareholders would share proportionally in the
monopoly profits. ANDREW J. SHERMAN & MILLEDGE A. HART, MERGERS AND
ACQUISITIONS A TO Z at 13 (2nd ed. 2005) (discussing the choice among
acquisition structures).
144
Note that the incentives of the empty voters themselves need not correspond
to the incentives of society at large for this to be true. For example, they could
be AcmeCo managers or employees concerned about losing their jobs after the
takeover. See, e.g., Jordan M. Barry & John William Hatfield, Pills and
Partisans: Understanding Takeover Defenses, 160 U. PA. L. REV. 633, 658
(2012). Multiple instances of empty voting have involved corporate managers
resisting takeover attempts. See, e.g., Paul Waldie, Arcelor Parks Dofasco in
Dutch Foundation; Move Seen as a Defense in Battle Against Rival Mittals
Takeover Attempt, THE GLOBE AND MAIL (CANADA), Apr. 5, 2006 (describing
how Arcelor management used empty voting to resist a takeover offer); The
Hungarian Defense, THE ECONOMIST, Aug. 9, 2007 (describing how MOL
management used empty voting to resist a takeover offer).
145
See, e.g., Bruce H. Kobayashi, & Larry D. Ribstein, Outsider Trading As an
Incentive Device, 40 U.C. DAVIS L. REV. 21 (2006); Larry Ribstein, The
Obscure Efficiency of Empty Voting, TRUTH ON THE MARKET, Dec. 17, 2010,
truthonthemarket.com/2010/12/17/the-obscure-efficiency-of-empty-voting/;
Alon P. Brav & Richmond D. Matthews, Empty Voting and the Efficiency of
Corporate Governance, Am. Fin. Assoc. 2009 San Francisco Meetings Paper,
available at papers.ssrn.com/.
143

25

about securities underlying values.146 The basic logic is that

collecting and processing this information is costly. The prospect
of entering into advantageous transactions with others who are less
informed induces parties to collect and process information.
Disclosure regimes enable other parties to learn of the new
information earlier than they would otherwise, reducing the initial
incentive to gather information and therefore market efficiency.
Hidden ownership mitigates all of these negative effects. Thus,
there may be instances in which it, too, is socially beneficial.
Accordingly, to enact a comprehensive response to
decoupling behavior, one must have a framework for analyzing
precisely when decoupling is problematic and when it is beneficial.
So far, such a framework has proven elusive. As we discuss
below, this is because competitive equilibrium, the most
commonly used framework for economic analysis, fails once
control rights are introduced.
III. COMPETITIVE EQUILIBRIUM AND THE CHALLENGE OF CONTROL
To study markets, economists employ models that abstract
and simplify real-world transactions. Although the details of these
models vary significantly, they generally share several basic
structural features: Each model, like each market, is composed of
various actors. Each actor has preferences with respect to different
combinations of goods that she might buy or sell.147 Using these
building blocks, economists can build frameworks with which to
analyze markets.
A. Competitive Equilibrium Generally
Competitive equilibrium is by far the most common
analytical framework that economists use. Given a set of actors
with specified preferences, a competitive equilibrium consists of a
market price for each good and an allocation of goods among the
actors. This allocation must be consistent with (1) each actor
acting to maximize her well-being, given market prices, and (2)
each actor being able to buy or sell as much of each good at its
market price as she wishes. In other words, given market prices, it
146

See, e.g., Easterbrook & Fischel, supra note 107; Schwartz, supra note 107.
They might also be able to produce, or consume goods. Since we are focused
on financial markets, we do not address these cases here.
147

26

cannot be possible for any actor to make herself better off by

buying or selling goods.
At a competitive equilibrium, all mutually beneficial trades
are consummated. There are no frustrated sellers or buyers;
anyone who wants to buy or sell at the prevailing market price may
do so. In essence, a competitive equilibrium is a set of prices at
which the market clears.148
A simple example helps illustrate these abstract points.
Consider a market with two actors, Alice and Bob, and one asset,
FirmCo stock. Assume that there are 100 shares of FirmCo stock,
that the value of each share is simply the present value of the
stream of future dividends that the owner of that share is expected
to receive,149 and that this amount is $10 per share. Consider the
outcome in which the share price of FirmCo stock is $10 and Alice
and Bob each own 50 shares. Alice and Bob are both acting in
ways that maximize their well-being; neither can make herself
better off by buying or selling shares. Accordingly, this outcome
is a competitive equilibrium.150
Competitive equilibria have a number of features that make
them such a useful analytical tool. First, competitive equilibria
have been proven to exist in a wide range of settings.151 Second, at
competitive equilibrium, there is no way to make any actor better
off without making at least one other actor worse off. This concept
is known as Pareto efficiency152 and, since competitive equilibria
have this property, they are referred to as Pareto efficient, or
simply efficient.153 Competitive equilibria can generally be
reached through voluntary trading, without outside intervention.154
Once a competitive equilibrium is reached, the market should be
148

See APPENDIX, supra note 33, at 1.1.

This is a common assumption in corporate finance, and we generally adopt it
going forward. See IVO WELCH, CORPORATE FINANCE (2d ed. 2011).
150
In this simple example, any allocation of shares between Alice and Bob
would also qualify. The key issue is that the price of FirmCo stock be $10.
151
See ANDREU MAS-COLELL ET AL., MICROECONOMIC THEORY 511-782 (1995)
(exploring competitive equilibrium under a wide variety of assumptions).
152
The term derives from the Italian economist Pareto. HAL R. VARIAN,
INTERMEDIATE MICROECONOMICS: A MODERN APPROACH 455 (4th
ed. 1996).
153
Id. When there is a numeraire good, as financial market models typically
assume, competitive equilibria are globally efficient as well as Paretto efficient.
154
MAS-COLELL ET AL., supra note 151, at 660-64, 694-99.
149

27

stable, as all transactions that improve the parties utilities have

been consummated.155
Finally, competitive equilibria offer
significant predictive power as to the outcome that particular
markets will produce; in many instances, competitive equilibria are
unique.156
Our simple competitive equilibrium example above
illustrates many of these properties. Since the example presented
constitutes a competitive equilibrium, a competitive equilibrium
exists. The outcome is stable, in that neither party has the ability
and incentive to move the market away from the given outcome.
The equilibrium provided is not unique, but in all competitive
equilibria, the market price of FirmCo stock is $10; thus,
competitive equilibrium provides a clear prediction about market
prices.
B. Competitive Equilibrium with Control Rights
Analyzing phenomena, such as empty voting, that involve
corporate decisions, requires a model that includes control rights.
Traditional economic models generally do not include meaningful
control rights. However, it is possible to augment such models by
adding in control rights. A natural step is to require that each actor
exercise such rights in accordance with her self-interest, just as
competitive equilibrium requires that each actor buy and sell in
accordance with her self-interest. In other words, for an outcome
to constitute a competitive equilibrium, an actor cannot be able to
make herself better off by either or both (1) buying or selling
goods at their market prices and (2) changing how she exercises
her control rights.
Unfortunately, once one introduces meaningful control
rights into standard economic models, competitive equilibrium
analysis becomes much less useful:157 Competitive equilibria may
cease to be efficient;158 worse, they may not exist at all.

155

Id. at 652-60.
Id. at 589-98, 606-16.
157
The appendix provides formal proofs of the statements in this section.
158
See Eddie Dekel & Asher Wolinsky, Buying Shares and/or Votes for
Corporate Control, 79 REV. ECON. STUD. 196 (2012) (finding inefficient
equilibria).
156

28

Simple examples are useful for illustrating these points.159

We begin with inefficiency. Consider two companies, FirmCo and
GiantCo, and four people, Alice, Bob, Carol, and Dan. Assume
that FirmCo and GiantCo each has 100 shares of stock outstanding
and that the aggregate value of each companys stock reflects the
entire economic value of that company.160 Alice, Bob and Carol
each have a one-third economic interest in GiantCo. Dan owns all
of FirmCo. GiantCos shareholders161 have the option to approve
or reject a proposed takeover of FirmCo.162 Alice, Bob and Carol
each have a one-third voting interest in GiantCo, and voting rights
are not transferable. The acquisition will take place if any two of
Alice, Bob, and Carol vote in favor of it; otherwise, it will not.
Suppose that if the takeover attempt fails, each share of GiantCo
stock will be worth $16, and each share of FirmCo stock will be
worth $6. On the other hand, if the takeover attempt succeeds,
each share of GiantCo stock will be worth $8, but each share of
FirmCo stock will be worth $21.163 Table 1 summarizes these
outcomes.

159

See also APPENDIX at 1.1.1 ex. 1.

In other words, assume that the company has no other outstanding classes of
equity or debt. We generally adopt this assumption in our examples throughout
the rest of the paper unless otherwise noted.
161
For simplicity, we assume that FirmCos shareholders approval is not
necessary; the analysis is essentially identical in both cases.
162
This example works equally well for any action requiring a shareholder vote.
163
Evidence suggests that this fact pattern is very common; empirical studies
generally find that acquirers returns from takeovers are either indistinguishable
from zero or slightly negative, but that the gains to target shareholders are
sizable and positive. See, e.g., Babu G. Baradwaj et al., Bidder Returns in
Interstate and Intrastate Bank Acquisitions, 5 J. FIN. SERVICES RES. 261 (1992)
(finding negative acquirer returns); Robert F. Bruner, Does M&A Pay? A Survey
of Evidence for the Decision-Maker, 12 J. APPLIED FIN. 48 (2002) (finding zero
returns for acquirers, positive for targets); David E. Bellamy & Walter M.
Lewin, Corporate Takeovers, Methods of Payment, and Bidding Firms
Shareholder Returns: Australian Evidence, 9 ASIA PACIFIC J. MGMT. 137 (1992)
(finding positive acquirer returns for cash deals, negative acquirer returns for
others); Elias Raad & H.K. Wu, Acquiring Firms Stock Returns, 18 J. ECON. &
FIN. 13 (1994) (similar); Sylvia C. Hudgins & Bruce Seifert, Stockholder
Returns and International Acquisitions of Financial Firms: An Emphasis on
Banking, 10 J. FIN. SERVICES RES. 163 (1996) (finding zero returns for
acquirers, positive for targets); Michael C. Jensen & Richard S. Ruback, The
Market for Corporate Control: The Scientific Evidence, 11 J. FIN. ECON. 5
(1983) (same).
160

29

GiantCo
Share Value
FirmCo
Share Value
Combined
Share Value

TABLE 1
Takeover Attempt
Fails

Takeover Attempt
Succeeds

$16

$8

$6

$21

$22

$29

Consider an outcome in which: (1) Alice, Bob, and Carol

each vote against the takeover; (2) GiantCo and FirmCo shares are
priced at $16 and $6, respectively; and (3) no one buys or sells
GiantCo or FirmCo shares. Alice, Bob, and Carol are all voting
consistently with their self-interest;164 each of Alice, Bob, and
Carol will have greater wealth if the takeover fails ($533)165 than if
it succeeds ($267).166 The prices of GiantCo and FirmCo
accurately reflect their value, given how Alice, Bob, and Carol are
exercising their control rights.167 No one would profit from buying
or selling a share of either stock at that price (possibly in
conjunction with changing their votes), so no one wishes to do so.
Thus, everyone is acting rationally in accordance with their selfinterest and the market clears, making this outcome a competitive
equilibrium.
However, it is easy to see that this outcome is inefficient.
If the takeover attempt fails, GiantCo and FirmCos combined
value will be $2200.168 On the other hand, if the takeover attempt
succeeds, their combined value will be $2900.169 Since $2900 is
more than $2200, it would be efficient for the takeover to take
place. The introduction of voting rights has resulted in competitive
equilibria that are not efficient.
One might wonder if this result were caused by dividing
control rights among Alice, Bob, and Carol. One might think that
vesting control rights in a single actor would solve the problem. It

164

We assume Dan is as well, but his vote does not matter.

Each would have one-third of the 100 GiantCo shares, worth $16 apiece.
166
Each would have one-third of the 100 GiantCo shares, worth $8 apiece.
167
Equivalently, given their voting behavior.
168
See Table 1, supra.
169
Id.
165

30

does not. In fact, unifying control rights can prevent competitive

equilibria from existing at all.170
Consider a scenario in which there are two firms, FirmCo
and GiantCo, and two people, Alice and Bob. Assume that
FirmCo and GiantCo each has 100 shares of stock outstanding and
that the aggregate value of each companys stock reflects the entire
economic value of each company. Initially, Alice and Bob each
own 50 shares of stock in FirmCo and GiantCo. In this example,
we again consider a proposed takeover of FirmCo by GiantCo.171
This decision affects the value of GiantCo as well as FirmCo, but
only the approval of FirmCo is necessary. Assume that Alice has
all of the FirmCo control rights, giving her complete control over
FirmCos decision, and that control rights are not transferable. If
FirmCo accepts the takeover offer, each share of FirmCo stock will
be worth $8, and each share of GiantCo stock will be worth $2.
On the other hand, if FirmCo rejects the takeover offer, both
FirmCo and GiantCo shares will be worth $4. Table 2 summarizes
these outcomes.

FirmCo
Share Value
GiantCo
Share Value
Combined
Share Value

TABLE 2
FirmCo Accepts
Takeover Offer

FirmCo Rejects
Takeover Offer

$8

$4

$2

$4

$10

$8

No competitive equilibrium exists: Given any set of prices

and proposed allocation of shares, it is always possible for Alice to
make herself better off by trading in FirmCo and GiantCo shares,
then changing FirmCos behavior away from what was expected.
We illustrate this by proof through contradiction.
The first key insight is that, at any competitive equilibrium,
the market prices of FirmCo and GiantCo shares must reflect their
expected values.172 The benefit of owning shares is the shares
170

See also APPENDIX, supra note 33, at 1.1.2 ex. 2.

This example works equally well for any action requiring a shareholder vote.
172
For simplicity, we assume that actors are risk-neutral.
171

31

expected value. The cost of acquiring shares is their prevailing

market price. If shares value exceeds their cost, buying shares
increases the buyers wealth.173 Thus, if the price of a firms
shares is less than the expected value of those shares, Alice can
make herself better off by buying the underpriced shares.174
Similarly, if either companys shares are priced above their
expected value, Alice can improve her well-being by selling that
companys shares.175 Recall that at a competitive equilibrium, no
actor can make herself better off by buying or selling goods at their
prevailing market prices. It therefore follows that, in any
competitive equilibrium, the market prices of FirmCo and GiantCo
shares must be their respective expected values.176
With this in mind, now suppose that there is a competitive
equilibrium in which FirmCo rejects the takeover offer. The
market prices of FirmCo and GiantCo shares must be $4, their
value if FirmCo rejects the offer. Alice can therefore sell all of her
shares of GiantCo, and purchase additional shares of FirmCo, for
$4 a share.177 Then, using her control rights over FirmCo, she can
cause FirmCo to accept the takeover offer. This will cause all of
her FirmCo shares to appreciate in value to $8, which will make
her strictly better off than she is at the supposed competitive
equilibrium.
For example, imagine that the proposed competitive
equilibrium has Alice owning 50 shares of FirmCo and 50 shares
of GiantCo. Each of Alices 100 shares is worth $4, giving her a
combined wealth of $400.178 If Alice sells all of her GiantCo
shares and buys all of the outstanding FirmCo shares, she will have
173

This would be equivalent to paying $10 for a stream of future payments

worth $20 today.
174
Bob, too, can employ this strategy.
175
The logic is the same; the shares pricethe benefit of sellingexceeds their
valuethe cost of reducing ownership. Again, Bob could also do this.
176
This follows from the risk-neutrality assumption. See note 172, supra.
177
This is always possible if Alice can increase her interest in FirmCo and
decrease her interest in GiantCo without boundand as derivatives markets
grow, this becomes ever closer to reality. But, even assuming that Alice can
own, at most, 100 FirmCo shares and, at least, 0 GiantCo shares, she still profits
by increasing her FirmCo ownership, reducing her GiantCo ownership, and
changing FirmCos response to the takeover offer. The only time she cannot do
this is if she owns 100 shares of FirmCo and 0 shares of GiantCo. However, this
is not a competitive equilibrium, because Alice can improve her utility by
changing her vote.
178
See Table 2, supra.

32

0 shares of GiantCo and 100 shares of FirmCo. If she then has

FirmCo accept the takeover offer, each of her 100 FirmCo shares
will appreciate in value to $8, giving her a total wealth of $800.179
Since $800 is more than $400, this represents an improvement in
Alices well-beingbut if the starting point is a competitive
equilibrium, as we assumed it to be, Alice cannot improve her
well-being.
Therefore, the starting point cannot be a competitive
equilibrium. Since our only assumption about the starting point is
that it is a competitive equilibrium in which FirmCo rejects the
takeover offer, there can be no competitive equilibria in which
FirmCo rejects the takeover offer.
Suppose instead that there is a competitive equilibrium in
which FirmCo accepts the takeover offer. The market prices of
FirmCo and GiantCo shares must be $8 and $2, respectively.180
Alice can therefore sell all her FirmCo shares for $8 each and buy
GiantCo shares for $2 each.181 Then, using her control rights over
FirmCo, Alice can cause FirmCo to reject the takeover offer,
causing all of her GiantCo shares to double in value to $4 and
making her strictly better off than she is at the supposed
competitive equilibrium.
For example, suppose the proposed competitive
equilibrium has Alice owning 50 FirmCo shares and 50 GiantCo
shares. The values of her FirmCo and GiantCo holdings are $400
and $100, respectively,182 making her total wealth $500. If Alice
sells all of her FirmCo shares and buys all 100 outstanding
GiantCo shares, she will have 0 FirmCo shares, 100 GiantCo
shares, and $300 cash. If she then has FirmCo reject the takeover
offer, her 100 GiantCo shares will appreciate to an aggregate value
of $400. Combined with her $300 cash, Alice will have $700 total
wealth. Since $700 is more than $500, this represents an
improvement in Alices well-beingbut, again, if the starting

179

See Table 2, supra.

See Table 2, supra.
181
The boundary issues discussed in note 177, supra, apply here. Again, they
are not problematic; it is not a competitive equilibrium if Alice owns 100 shares
of GiantCo (the maximum) and 0 shares of FirmCo (the minimum), because
Alice can double her utility by changing her vote.
182
See Table 2, supra.
180

33

point is a competitive equilibrium, as we assumed, Alice cannot

improve her well-being.
Therefore, this starting point cannot be a competitive
equilibrium, either. Since our only assumption about the starting
point is that it is a competitive equilibrium in which FirmCo
accepts the takeover offer, it therefore follows that there are no
competitive equilibria in which FirmCo accepts the takeover offer.
But FirmCo can only respond to the outstanding takeover
offer in one of two ways: it must either reject or accept the offer.183
If neither of these choices is compatible with a competitive
equilibrium, then no competitive equilibrium is possible.
Introducing control rights renders competitive equilibrium an
impossibility.184
Conceptually, the issue is that Alice can always use her
control power to make herself better off by doing the following:
First, she buys assets that will increase in value if the result of the
shareholder vote is not what people expect.185 This is essentially
betting that the vote will not play out how other actors expect.
Second, she uses her voting power to switch the result of the
shareholder vote away from what others expect. This ensures that
she wins her earlier bet. This strategy, which we refer to as Bet
and Switch, prevents any particular outcome from ever
constituting a competitive equilibrium.

183

Theoretically, FirmCo could accept probabilistically. In other words, Alice

could flip a coin, and cause FirmCo to accept the takeover offer only if it comes
up heads. However, no equilibria fit this mold, either. The proof is essentially
identical in format to the proofs that there are no equilibria in which FirmCo
accepts the takeover offer and no equilibria in which FirmCo rejects it; Alice
can make a profit by buying or selling FirmCo or GiantCo shares then
increasing or decreasing the probability that FirmCo accepts.
184
These results are broadly consistent with other works demonstrating how
information asymmetries can cause markets to unravel. See George A. Akerlof,
The Market for Lemons: Quality Uncertainty and the Market Mechanism, 84
Q.J. ECON. 488 (1970) (showing how markets can unravel when parties have
asymmetric information about values); Paul Milgrom & Nancy Stokey,
Information, Trade and Common Knowledge, 26 J. ECON. THEORY 17 (1982)
(presenting a result, known as the no-trade theorem, that says that under certain
conditions, financial markets will produce no trades because any offer to buy or
sell conveys information to counterparties that they would be foolish to accept
the offer).
185
She also sells assets that will decrease in value in the same circumstances.

34

C. Competitive Equilibrium with Transferable Control Rights

Thus far, our models have not allowed actors to transfer
control rights. But, in the real world, control rights generally
depend on share ownership. Since shares are transferable, so are
control rights. One might hope that modifying the model to allow
the transfer of control rights would solve these problems with
competitive equilibrium analysis.
Unfortunately, the exact opposite is true; making control
rights transferable makes competitive equilibrium analysis even
more problematic.186 If one assumes that control rights and
economic rights trade together as a single package, with a single
pricei.e., a world with small derivatives markets, in which firms
have one class of stockthen competitive equilibria will not exist
if there is at least one decision whose outcome has a substantial
effect on at least one other firm.187 Since a firms actions often
have significant implications for its competitors,188 suppliers,189
customers,190 and producers of complementary products,191
competitive equilibria will often not exist.
To see why competitive equilibria become so rare, observe
that making control rights transferable for a specified price has the
effect of fixing a price for control. For example, suppose that a
share of FirmCo stock has a price of $10 and carries a 1% voting
interest in FirmCo. If 51% of FirmCo votes are required to exert
control over FirmCo, any actor can acquire control of FirmCo by
acquiring 51 FirmCo shareswhich she can do at a cost of $510.

186

See also APPENDIX, supra note 33, at 2.1.

More specifically, any firms decision must have a larger effect on the value
of any bloc of shares with sufficient control rights to control that decision than
on all other traded items combined. So, if a corporation has one class of stock,
no debt, and control requires a majority of outstanding shares, this means that all
of the corporations decisions must have twice as large an effect on the value of
the corporations own shares than on all other traded items, combined. This is
unlikely if any item whose value is affected by any of the corporations
decisions has a large derivatives market.
188
See Hu & Black, supra note 8, at 844-45 (discussing the example of Ford and
GM); Bankman & Ayres, supra note 84 (similar).
189
See Bankman & Ayres, supra note 84 (discussing how investors can take
advantage of such relationships).
190
Id.
191
See Barry, supra note 137 (discussing in intellectual property context).
187

35

Thus, for a fixed price ($510), an actor can acquire the

power to control FirmCos decisions. If FirmCos decisions affect
the value of other items, that actor can employ the Bet and Switch
strategy discussed above.192 That is, she can enter into transactions
that become profitable if FirmCo acts in a way that others do not
expect, then cause FirmCo to behave in precisely that unexpected
way. So long as she can enter into enough such transactions, her
profits will exceed the fixed cost of acquiring control over FirmCo.
Competitive equilibria are even less likely to exist when
as large derivatives markets allowcontrol rights and economic
rights trade separately.193 In such circumstances, competitive
equilibria will not exist if any firms decision affects the value of
anythingincluding the value of the firm itself. The logic is the
same as when control and economic rights trade as a single
package: an actor can acquire control of a firm for a fixed price,
then employ the Bet and Switch strategy. However, because one
can now purchase a control right without also acquiring significant
economic rights, the strategy becomes cheaper and can be
profitably employed in more circumstances.
This is precisely what happened with respect to the bid for
Henderson Investments discussed earlier.194 The bid was expected
to succeed, and Henderson Investments stock price reflected
this.195 The hedge fund quietly acquired enough Henderson
Investments votes to be able to prevent the takeover offer from
succeeding.196 The hedge fund then entered into short sale
transactions with respect to Henderson Investments stock.197
These transactions would yield a profit if, counter to expectations,
Henderson Investments rejected the takeover offer.198 Finally, the
hedge fund voted against the offer, which prevented the takeover,
surprised market watchers, and yielded the hedge fund a tidy profit
on its short sale transactions.199

192

See Part III.B.2, supra.

See also APPENDIX, supra note 33, at 2.1 thm 5.
194
See Part I, supra.
195
Gimbel & Guerrera, supra note 2.
196
McMillan, supra note 6.
197
Id.
198
Id.
199
Hong Kong Shares Fall 0.1 Percent, But China-Related Issues Continue To
Do Well, supra note 5.
193

36

In short, competitive equilibrium is ill-suited to analyzing

markets with control rights. When derivatives markets are sizable,
competitive equilibria will not exist if control rights have any
meaningful economic consequences.
Another economic
framework is necessary.
IV. THE CORE OUTCOME
We propose a new equilibrium concept for markets with
control rights:200 the core outcome.201 For an outcome to constitute
a core outcome, it cannot be possible for any group of actors to
change their behavior in a way that makes the group as a whole
better off.202 For this purpose, a group can consist of a single
actor.203
It is helpful to illustrate the core outcome concept with a
simple example. Suppose that, initially, all actors have the same
portfolio of assets and control rights. Suppose that there are no
trades and every actor votes in her own best interest (which is also
the groups best interest because each actor has the same
portfolio). This is a core outcome.
To see this, first observe that intra-group sales and
purchases leave the groups collective assets unchanged; the only
way to make the group better off as a whole204 is to change one or
more firms decisions. Recall that every actor holds the same
portfolio. Therefore, if changing a firms decision improves the
value of the groups portfolio, it must also improve the value of all
actors portfolios. But if there is a way to improve the value of
everyones portfolio by changing some actors votes, that means
that some actors are not voting according to their self-interests.
200

In doing so, we adapt from a concept in cooperative game theory known as

the core. See MYERSON, supra note 27, at 417-482.
201
The Appendix addresses this issue with more formality and mathematical
rigor. It also uses slightly different terminology. The description adopted here
is intended to facilitate an understanding of the concepts. The interested reader
looking for a more formal discussion should refer to the Appendix.
202
This is equivalent to showing that there is no way to make every group
member better off. See APPENDIX, supra note 33, at 1.2. Essentially, if the
groups winners gain more than its losers lose, they could (over-)compensate the
losers for their losses and remain winners.
203
See APPENDIX, supra note 33, at 1.2. However, as discussed below, all that a
single actor can change alone is her vote; buying or selling requires a
counterparty.
204
Or worse.

37

However, this creates a contradiction, because we assumed that

every actor was voting in her own best interest. Thus, there cannot
be any group that can defect and make its members better off,
making this a core outcome.
The core outcome has some very desirable properties that
make core outcome analysis attractive. Many of these are qualities
that make competitive equilibrium analysis so useful in other
contexts.
Chief among them are existence, efficiency,
voluntariness, stability, reasonableness, and predictive power. All
of these properties hold regardless of whether control rights are
non-transferable, tradable in a package with ownership interests, or
separately transferable.205
A. Existence
Core outcomes always exist.206 The touchstone of both
competitive equilibria and core outcomes is that, in each instance,
actors are maximizing their well-being. Yet, in markets with
control rights, core outcomes always exist but competitive
equilibria often do not. It is helpful to explore the intuition behind
this difference.
Competitive equilibrium focuses on whether each
individual actor is maximizing her well-being. It assumes that
each actor can always buy or sell goods at their market prices; a
counterparty is always available. If control rights are tradable,
then any actor can acquire control power for a fixed price.207 It
also generally enables an actor with control power to employ the
Bet and Switch strategy: If there is a Bet availablethat is, an
asset she can buy that will increase in value if a firm makes an
unexpected decisionthere are always (assumed) counterparties to
take the other side of the Bet. The actor can then use her control
power to win the Bet, making herself better off and preventing the
initial outcome from being a competitive equilibrium.208

205

See APPENDIX, supra note 33, at 1.2, 2.2.

See APPENDIX, supra note 33, at 1.2.2 thm 2, 2.2.2 thm 7.
207
See Part III.C, supra. The cost drops significantly if control rights trade
separately from economic rights. Id.
208
See Part III.B, supra. If control rights trade separately from economic rights,
it is even rarer for competitive equilibrium to exist. See Part III.C, supra.
206

38

The core outcome, in contrast, looks to deviations by

coalitions.209 It does not assume that actors can automatically buy
or sell at prevailing market prices; to buy or sell, there must be a
counterparty in the deviating coalition to transact with the
defecting individual. Thus, in contrast to competitive equilibrium,
defecting must benefit the defectors as a group, not just one of
them.210
Intuitively, the Bet and Switch strategy allows a party with
control to earn profits by confounding other parties expectations.
However, these profits are often less than the losses she inflicts on
her counterparties.211 Put another way, if the profiting partys
counterparties had known what she was doing, they would not
have agreed to transact with her. The strategy requires the party
with control to conceal what she is doing from the other parties
essentially, to trick them.
The core outcome framework severely restricts the Bet and
Switch strategy because it considers all the defectors in its
calculus. Only deviations that benefit the transacting parties as a
group are possible. Thus, this strategy often is not viable in the
core outcome context when it would move the market to a less
socially efficient outcome.
To illustrate this, let us reconsider our example from Part
III.B.2 in which we showed that no competitive equilibrium exists:
There are two firms, FirmCo and GiantCo, each with 100 shares of
stock outstanding, and two people, Alice and Bob. Alice and Bob
each own 50 shares of stock in FirmCo and GiantCo. FirmCo is
considering whether to accept a takeover offer,212 a decision that
affects the value of GiantCo as well as FirmCo.213 Assume that
Alice has all of the FirmCo control rights, so that she has complete
control over FirmCos decision, and that control rights are not
transferable. Suppose that if FirmCo accepts the takeover offer,
each share of FirmCo stock will be worth $8, and each share of
GiantCo stock will be worth $2. On the other hand, if FirmCo
209

See APPENDIX, supra note 33, at 1.2, 2.2.

Compare APPENDIX, supra note 33, at 1.2, 2.2 with APPENDIX, supra note 33,
at 1.1, 2.1.
211
See text accompanying notes 172179, supra.
212
This example works equally well for any action requiring a shareholder vote.
213
Perhaps GiantCo makes competitive or complementary products, for
example.
210

39

rejects the takeover offer, a share of its stock will be worth $4, as
will each share of GiantCo stock. Table 3, below, summarizes
these results.

FirmCo
Share Value
GiantCo
Share Value
Combined
Share Value

TABLE 3
FirmCo Accepts
Takeover Offer

FirmCo Rejects
Takeover Offer

$8

$4

$2

$4

$10

$8

We previously established that no competitive equilibrium

exists.
However, core outcomes do exist. For example, suppose
that Alice and Bob initially own 50 shares of stock in FirmCo and
GiantCo. If there are no trades;215 and Alice has FirmCo accept
the takeover offer, the result is a core outcome.216
214

Recall that to constitute a core outcome, there must not be

any way for any group of actors to change their behavior and make
themselves better off as a whole. There are three possible
deviating coalitions: either Alice or Bob could act alone, or both
could act together.
If either acts alone, her final portfolio must match her
initial portfolio; purchasing or selling FirmCo or GiantCo stock
requires a counterparty with which to transact. All that a single
defector can do is change her vote. However, Alice and Bobs
initial portfolios each contain an equal amount of FirmCo and
GiantCo stock. Since accepting the takeover bid maximizes
FirmCo and GiantCos combined value, it also maximizes the
value of Alice and Bobs respective portfolios. Therefore, neither

214

See Part III.B, supra.

This example assumes no trades for simplicity, there are many other initial
endowments that can support to reach this same core outcome. To take one
example, suppose Alice begins with all of the economic interest in GiantCo and
Bob begins with all of the economic interest in FirmCo. See Part IV.E, infra.
216
Note that this example is essentially identical to the example core outcome
provided at the beginning of this Part. See notes 203-205, supra, and
accompanying text.
215

40

party can make herself better off by keeping her initial portfolio
and changing her vote.217
The only other possible coalition involves Alice and Bob
deviating together. Between them, Alice and Bob own all of the
economic interests in FirmCo and GiantCo. Thus, their aggregate
well-being is just the two companies combined value. Since the
current outcome maximizes that sum; no deviation can raise it
further. Thus, there is no coalition of actors that can improve their
well-being relative to this outcome. Accordingly, this outcome is a
core outcome.
B. Efficiency
Once one has proven that core outcomes always exist, it is
straightforward to show that they are also efficient.218 If an
outcome is inefficient, that means a more efficient outcome is
possible. All of the actors in the market could then form a
deviating coalition and, by changing their behavior, shift the
market to that more efficient outcome. This would, by definition,
raise the well-being of the group as a whole.219 However, if the
initial outcome was a core outcome, it should not be possible for
any group of actors to increase its overall well-being by changing
its behavior. Thus, if the initial outcome was not efficient, it
cannot have been a core outcome; no inefficient core outcomes
may exist.
C. Voluntariness and Stability
The mere fact that a core outcome exists does not, a priori,
mean that the market will reach a core outcome. However, core
outcomes have two additional features that make this result far
more likely. The first is that, for any initial allocation of securities
and control rights, there is at least one core outcome that leaves
every actor at least as well off as she started. This means that it is
always possible for the market to achieve a core outcome through
voluntary trades: No matter what the condition of the market is at

217

Note that Bob does not even have any votes in this example.
APPENDIX, supra note 33, at 1.2.1 thm 1, 2.2.1 thm 6.
219
An improvement in the aggregate utility of the group can be translated into
an improvement in the utility of each of the members through transfers. See
Appendix.
218

41

any moment, there is always a core outcome that all of the parties
would happily accept. We term this feature voluntariness.
To illustrate this, suppose that each actor starts with an
initial endowment of assets and some plan for how she will
exercise her control rights.220 Actors then trade among themselves
so that each actor holds what is known as the market portfolio
that is, each actors portfolio contains the same mix of securities as
the market as a whole.221 The parties trade each security at the
value it is expected to have assuming all actors vote as planned.222
For example, suppose Alice initially held 100 FirmCo
shares and 50 GiantCo shares, and Bob initially held 50 GiantCo
shares. The parties would trade shares between them until each
portfolio contains the same blend of securities. If GiantCo and
FirmCo have the same expected value, Alices final portfolio will
be 75 FirmCo shares and 75 GiantCo shares, while Bobs would be
25 FirmCo shares and 25 GiantCo shares.223 Both initially and
ultimately, Alice holds 75% of all assets and Bob holds 25%. All
that changes is which assets make up their portfolios.
After the trading is done, actors vote in their self-interest
and, since everyone has the same mix of securities in their
portfolio, this causes firms to make the decisions that maximize
total social welfare. This produces a core outcome in which all
actors are at least as well off as they started.
To see why this is a core outcome, we apply the same logic
as in our very first core outcome example.224 The only way for a
deviating group to make itself better off as a whole is to change
one or more firms decisions. Because every actor holds the
market portfolio, any change in firms decisions that increases the
value of the groups portfolio also increases the value of all actors
220

See also APPENDIX, supra note 33, at 1.2, 2.2.

See WELCH, supra note 149 (discussing the market portfolio).
222
See APPENDIX, supra note 33, at 1.2 thm 2, 2.2 thm 7. The total amount of
securities that each actor ultimately holds will vary based on the differing values
of the parties initial endowments.
223
The exact mix would depend on the relative values of FirmCo and GiantCo
shares. If FirmCo is more valuable than GiantCo, Alice will ultimately have
more than 75% of outstanding shares; if GiantCo is more valuable than FirmCo,
Alice will have less than 75% of outstanding shares, though not less than 50%.
See APPENDIX, supra note 33, at 1.2 thm 2, 2.2 thm 7.
224
See text accompanying notes 203205, supra.
221

42

portfolios. But since every actor was already voting in her best
interest, this is impossible. Thus, no group can defect and make its
members better off, making this a core outcome.
To see why each actor is at least as well off as she was
initially, recall the trades that each actor made: she made evenvalued trades to convert her initial portfolio into the market
portfolio with the same value. Therefore, each actors initial and
final portfolios both contain the same fraction of the value of all
assets in the market. In other words, each actors initial and final
portfolios represent the same fraction of the total economic pie.
Since the final outcome is a core outcome, it must be efficient,225
meaning that the total value of all assets in the market is
maximized. Sticking with the pie analogy, the core outcome must
produce at least as large an economic pie as the initial endowment
and voting plan did. Each actor ends with the same-proportioned
slice of a pie that is at least as large as the initial pie. Accordingly,
each actor is at least as well off as she was initially.
A second property, which we call stability, complements
voluntariness. Recall that, at a core outcome, no individual, pair,
or larger group of actors can coordinate their behavior and make
themselves better off. That means no one has any incentive to
change the status quo. This makes core outcomes stable; once a
market reaches a core outcome, it should be expected to stay there.
On the other hand, if the market is not at a core outcome,
then there is a group of actors that would all be better off if they
were to jointly deviate from the status quo. Thus, a non-core
outcome is subject to instability and potentially rapid change
including to another non-core outcome that itself may rapidly
change.
Together, voluntariness and stability paint an encouraging
picture: No matter what happens, there will always be a core
outcome to which all actors would agree. Non-core outcomes are
unstable and likely to be temporary, but once a core outcome is
achieved, it should endure. These insights give a mechanism by
which markets will gravitate toward core outcomes.

225

See Part IV.B, supra.

43

D. Reasonableness
Core outcomes have another feature that, while less
formally defined than those discussed so far, is just as important
for real-world applications: Core outcomes are not bizarre and
pathological; they resemble many real-world outcomes. Nor are
they so-called knife-edge portfolios, vulnerable to small changes
in actors portfolios or voting behavior.226
Consider the core outcome described in the previous
section, in which actors traded amongst themselves until each
actors portfolio mirrored the entire market.227 This scenario is
consistent with what traditional theories of portfolio selection
would recommend: all investors should diversify their holdings
and limit their risk by acquiring the market portfolio. In the real
world, this prediction does not play out precisely, presumably due
to various frictions in financial and other markets.228 Nonetheless,
the observed behavior of financial market participants substantially
conforms to this model in many cases.229
Such real-world scenarios will generally constitute core
outcomes.230 The fact that core outcomes are largely consistent
with accepted portfolio theory and long-running real-world
behavior strongly bolsters the core outcome framework.
E. Predictive Power
All of the core outcomes associated with a particular
market share a number of features. This makes the core outcome
framework a powerful analytical tool for predicting markets
behavior.
One key feature is that all core outcomes associated with a
particular market produce the same total social utility.231 This
follows from our previous result that all core outcomes are
226

Cf. Marco Pagano, Trading Volume and Asset Liquidity, 104 Q.J. ECON. 255,
265 (1989) (discussing knife-edge conditions).
227
See Part IV.C, supra.
228
For example, there are transaction costs, taxes, and agency costs with respect
to public company management that can be reduced through incentive
compensation arrangements. See Coase, supra note 116; POSNER, supra note
136, at 402.
229
See Goetzmann & Kumar, supra note 30.
230
See APPENDIX, supra note 33, at 1.2, 2.2.
231
See also APPENDIX, supra note 33, at 1.2, 2.2.

44

efficient:232 A core outcome would not be efficient if it provided

less social utility than another core outcome. Thus, all core
outcomes must create the same amount of total social utility.
This insight produces another one:
Since different
decisions by firms generally produce varying amounts of total
social utility, and all core outcomes create the same amount of
social utility, firms decisions must generally be the same across
all core outcomes. In other words, firms should make the same
decisions in every core outcome.233 Thus, the core outcome
framework offers exact predictions of firms decisions.
Core outcomes are not unique, so one cannot predict the
precise portfolio that each actor will hold. However, the core
outcome gives a range of predictions as to what the actors final
portfolios will be.
To illustrate this, we revisit a previous example.234
Consider two firms, FirmCo and GiantCo, each with 100 shares
outstanding, and two people, Alice and Bob. Alice owns all the
FirmCo shares and Bob owns all the GiantCo shares. Alice has all
of the control rights over FirmCo, Bob has all of the control rights
over GiantCo, and control rights are not transferable. GiantCo is
considering acquiring FirmCo, a transaction that must be approved
by both firms shareholders.235 If shareholders approve the
takeover, each FirmCo share will be worth $8, and each GiantCo
share will be worth $2. On the other hand, if shareholders reject
the takeover, each FirmCo and GiantCo share will be worth $4.
Table 4 summarizes these results.

232

See Part IV.B, supra.

It is possible to construct examples in which different combinations of
decisions provide the exact same (efficient) level of social welfare. For
example, suppose that there are two decisions, and the combined value of all
companies is maximized if both decisions are yes or both are no. In the real
world, however, it is unlikely that any two different decisions will produce
exactly the same values.
234
See Parts III.B.2, IV.A, supra.
235
This example works equally well for any action requiring a shareholder vote.
233

45

FirmCo
Share Value
GiantCo
Share Value
Combined
Share Value

TABLE 4
Shareholders
Approve Takeover

Shareholders
Reject Takeover

$8

$4

$2

$4

$10

$8

If Alice and Bob engage in voluntary transactionseither

share-for-share trades or sales of shares for cashuntil they reach
a core outcome, what possible portfolios might each ultimately
hold?
First, recall that all core outcomes are efficient.236 This
corresponds to FirmCo accepting the takeover offer, which
maximizes the combined value of both companies.237 If both
parties keep their initial portfolios, the takeover offer will fail.
This is because, initially, Bob only owns GiantCo stock, and
rejecting the takeover offer maximizes GiantCos value.238 In such
a scenario, Alice and Bobs respective portfolios would each be
worth $400. Thus, if both Alice and Bob only engage in trades
that further their self-interest, each partys final portfolio must be
worth at least $400.
Next, recall that, to be a core outcome, there must not be a
way for any group of actors to change their behavior and make
themselves better off. As noted previously, the only possible
deviating coalitions entail Alice or Bob acting alone or both of
them acting together. For any outcome in which FirmCo accepts
the offer, Alice and Bob cannot change their behavior and make
themselves both better off.239 If Alice or Bob deviates alone, all
either can do is change how she votes. Thus, each partys final
portfolio must make it in her interest to approve the takeover.

236

See Part IV.B, supra.

Alice and Bobs combined well-being is the aggregate value of FirmCo and
GiantCo. That amount is $1000 if the takeover happens, but only $800 if it does
not. See Table 4, supra.
238
See Table 4, supra.
239
Again, Alice and Bobs combined well-being is just the sum of the
companies values, and that sum is maximized when the takeover happens.
237

46

There are a number of possible outcomes that satisfy these

criteria and therefore constitute core outcomes.240 Because Alice
and Bob must own all the outstanding shares of FirmCo and
GiantCo between them, knowing one partys holdings specifies all
parties holdings.241 It is therefore possible to represent the entire
distribution of shares by showing Alices final portfolio.242 Figure
1, below, shows the possible share distributions between Alice and
Bob graphically.243 Point A, in the lower right hand corner,
represents Alices initial portfolio. The shaded regions represent
all of the final portfolios that are consistent with a core outcome
and that satisfy the voluntariness condition. The darker shaded
region shows the portfolios achievable through share-for-share
trades alone, and the lighter shaded region includes those realizable
with cash transfers. The dotted diagonal line represents the
outcomes in which Alice and Bob hold the market portfolio.
FIGURE 1: ALICES FINAL PORTFOLIO

Thus, while the core outcome framework does not allow us to

predict the exact portfolios that actors will hold, it does give us a
range of possibilities. Combined with the unique predictions that it
240

If portfolios must include whole numbers of shares, and cash transfers are not
possible, there are 10,201 possible portfolios, 1,701 of which are core outcomes.
241
Bobs portfolio must be whatever shares Alice does not own. In other words,
for any company, the number of shares that Bob holds must be 100 minus the
number of shares that Alice holds.
242
If our model also included Carol, producing a comparable graph would be
much more difficult.
243
Note that Figure 1 does not show how much cash Alice or Bob hold.

47

provides about asset values and firms decisions, the core outcome
framework provides a clear picture of the outcome a market will
reach.
V. IMPLICATIONS OF THE CORE OUTCOME FRAMEWORK
We now turn to the social welfare implications of the core
outcome framework. We begin by considering the implications of
growing derivatives markets and the concomitant expansion of
decoupling.
We then explore various potential regulatory
responses. Finally, we examine how sensitive these predictions are
to certain assumptions underlying the model.
A. Implications of the Growth of Derivatives Markets and
Decoupling
Some have argued that derivatives markets simply enable
the market for the underlying securities to respond to new
information better and faster.244
Thus, the only effect of
derivatives market growth is an improvement in the efficiency of
the market for the underlying security.
Some commentators and pundits have rejected this view,
particularly in the wake of the recent financial crisis.245 They have
argued that the growth of derivatives markets could have other,
and potentially negative, consequences for the market for the
underlying security.246 However, this group has had difficulty
articulating a rigorous explanation of the negative consequences
that flow from a larger derivatives market and identifying the
precise mechanism through which these consequences take place.
244

Scholars in this camp contend that, at worst, derivatives may increase

volatility in the underlying market. See, e.g., Myron S. Scholes, Global
Financial Markets, Derivative Securities, and Systemic Risks, 12 J. RISK &
UNCERTAINTY 271 (1996) (arguing that derivatives increase efficiency and do
not pose systemic risks); Sung C. Bae et al., Futures Trading, Spot Market
Volatility, and Market Efficiency: The Case of the Korean Index Futures
Markets, 24 J. FUTURES MARKETS 1195 (2004); Ren M. Stulz, Demystifying
Financial Derivatives, 2005 MILKEN INSTITUTE REVIEW 20, 25-26.
245
See, e.g., Lynn A. Stout, Betting the Bank: How Derivatives Trading Under
Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial
Markets, 21 J. Corp. L. 53 (1995); PARTNOY, supra note 81, at 402.
246
Other critics have focused more on derivatives effects on systemic risk. See,
e.g., Colleen M. Baker, Regulating the Invisible: The Case of Over-the-Counter
Derivatives, 85 Notre Dame L. Rev. 1287, 1308 (2010); Testimony of Richard
Bookstaber Submitted to S. Comm. Agriculture, Nutrition, and Forestry 4 (June
4, 2009).

48

Similarly, this group has lacked a generalized formal economic

model that supported its position.
Our analysis fills all of these gaps. It provides the first
generalized formal support for the notion that the size of the
derivative markets for a security can have major and, potentially
(but not exclusively), negative consequences for the operation of
capital markets. It also illustrates the mechanism through which
these negative consequences are generated.
Before the growth of large derivatives markets, ownership
and control generally tended to align; actors with large voting
interests in firms usually had comparably large economic
interests.247 Thus, it seemed likely that those with control rights
would generally exercise them in the best interests of the
corporation. So long as public and private regulatory forces
aligned firms incentives with the general publics, almost any
allocation of shares would typically constitute a core outcome.248
It was not necessary to consider the allocation of economic or
voting rights, and there was no concern about decoupling; it was
generally sufficient to focus on share prices. This state of affairs
worked well with competitive equilibrium analysis.
But this view of the financial markets is becoming
increasingly untenable. Modern derivatives markets are large,
which allows investors to have control rights over a corporation
without a corresponding economic interest. Ownership and control
need not be correlated, let alone identical. In the absence of
disclosure, this can lead to many non-core outcomes. As
derivatives markets continue to grow, ownership and control
should only be expected to diverge further. The theory predicts
that there will be empty voting, as well as hidden and morphable
ownership,249 and this has been borne out in practice.250 Focusing
247

Of course, there have always been exceptions, such as corporations with

classes of stock that differ in their voting and economic rights.
248
Without large derivatives markets, any actor with enough voting power over
a firm to implement Bet and Switch strategy would generally have a large
positive in that firm. If firms incentives align with societys, there will be few
assets that significantly increase in value when a firm makes a decision that does
not maximize its value. Combined, that means making the Switch will be
costly and the actor will not be able to place enough Bets to reap a profit.
249
See APPENDIX, supra note 33, at 1.2, 2.2.
250
See Hu & Black, supra note 1, at 661 tbl.1 (collecting many examples).

49

on securities prices will no longer be enough; market participants,

regulators, and observers must keep track of how economic
interests and control rights are allocated among actors.
This increase in empty voting makes it more likely that
votes by a firms shareholders will not produce decisions that
maximize the firms value. If regulation effectively aligns firms
incentives with societys, this result is troubling; empty voting
would promote socially inefficient decisions. Thus, one might be
concerned about large or growing and unregulated derivatives
markets.251
However, there are a number of instances in which public
and private regulation may fall short: Antitrust regulators could
erroneously allow two duopolists to merge into a single monopoly
firm.252 Environmental regulations might be too lax, so that a firm
is not forced to take into account the full amount of the
externalities that its actions will impose.253 Corporate governance
arrangements might give managers too much power.254 Even
perfect legal rules will be inadequate if agencies or counterparties
lack the resources to enforce them with sufficient vigor. Other
examples abound.255
In such situations, large derivatives markets can increase
efficiency by making it easier for the actors who would be hurt by
the firms actions to steer the company toward a more socially
beneficial decision. In other words, a large derivatives market may
serve as a private backstop to regulation: It can increase private
actors ability to block socially inefficient actions that regulation
would allow.
For example, suppose that FirmCo plans to build a new
factory, but doing so requires a shareholder vote.256 Building the

251

Large derivatives markets provide other benefits, such as improved liquidity

in underlying markets, that may offset these effects. See PARTNOY, supra note
81, at 4-5; Fleischer, supra note 86, at 229-30.
252
POSNER, supra note 136, at 387-89.
253
Id. at 506.
254
See Ribstein, supra note 145.
255
See Part II.E, supra.
256
Such actions generally do not require shareholder votes. A scenario more
likely to require such a vote would be if there were a board of directors election
in which different slates of directors had opposing views on the expansion plan,

50

factory will raise FirmCos profits by $1 million, but it will also

pollute a nearby lake, leading to $2 million in lost profits to
GiantCo.257 Building the factory is socially detrimental, since the
costs to GiantCo outweigh the benefits to FirmCo. Nonetheless, in
the absence of regulation to align FirmCos interests with
societys, building the factory is profitable for FirmCo and its selfinterested shareholders will therefore approve it. In this scenario,
empty voting, which makes it more likely that the shareholder vote
will not reflect FirmCos interests, would be a good thing. Empty
voting offers GiantCo a path to block the transactionessentially,
a mechanism for it to correct a regulatory failure.
Empty voting may also improve social welfare indirectly
by facilitating more efficient allocations of control and information
rights.258 When shareholders exercise their control rights over a
firm, they do so from a place of uncertainty. They do not know
what will happen in the future, either within the firm or the
economy as a whole. Shareholders have some information,
however; they receive signals about the current state of the world
and how it is likely to progress in the future, and they make
decisions based on their interpretations of these signals. The
quantity and quality of signals that shareholders receive, their
ability to interpret them, and their ability to influence management
all vary. By separating voting and ownership, large derivative
markets allow shareholders to allocate decision rights to the
shareholders best-equipped to wield them. This allows the
shareholders to maximize expected social value.
To take a simple example, suppose there are two
shareholders in a corporation: Alice and Paul. Both shareholders
want to maximize the corporations value. Alice is an active
shareholder who knows a lot about the firms line of business and
carefully follows its activities. Paul is a passive shareholder who
does neither of these things. The uninformed Paul might want to

or if the company were acquiring an existing enterprise that it planned to

expand. The distinction is not important for this discussion.
257
GiantCo could be in the fishing or tourism industries, for example. Note that
this example would work the same way if the factory produced psychic loss to
recreational users of the lake or environmentalists.
258
See Ribstein, supra note 145.

51

give his control rights to the informed Alice, on the logic that she
shares his interests and will presumably make better decisions.259
A similar dynamic has played out several times in
securities markets.260 Consider the hedge fund Laxey Partners.
After Laxey invests in a company, it frequently agitates for
measures that it believes will benefit shareholders.261 To increase
its leverage over corporate management, Laxey sometimes
increases its control well beyond its economic ownership; in other
words, it becomes an empty voter. For example, in one instance,
Laxey increased its voting interest to a whopping nine times its
economic interest.262
Similarly, hidden ownership can encourage shareholders to
better monitor managers and to make better decisions. Acquiring
and processing information about a company takes time and effort.
If many investors each own a small share of a corporation, each
will be tempted not to spend his own resources acquiring
information and to instead free-ride off other investors efforts.263
The larger a shareholders economic interest, the more likely he
will be to expend resources acquiring and processing
information.264 Derivatives markets make it easier for existing
shareholders to increase their economic interest.265 Thus, hidden
ownership can encourage information gathering and combat the
free-rider problem.
Neither empty voting nor hidden ownership is strictly
necessary to achieve these benefits. In theory, they can all be
259

This mirrors the corporations separation of ownership and control, in which

shareholders give managers the right and obligation to run the corporation on a
day-to-day basis. BAINBRIDGE, supra note 35, at 197-207; see also WELCH,
supra note 149 (discussing the efficient capital market hypothesis, which
predicts that, on average, carefully observing corporations actions will not let
investors earn higher returns).
260
For other examples, see Hu & Black, supra note 1, at 661 tbl.1.
261
We take no position as to whether Laxeys views are correct, or whether they
are good for society as a whole.
262
See Algernon Craig Hall, Laxey Turns up the Heat on British Land,
CITYWIRE MONEY, Feb. 27, 2003, available at citywre.co.uk/money/.
263
See BAINBRIDGE, supra note 35, at 35-38.
264
Id. Alternatively, one can attack the free-rider problem more directly. See
Jordan M. Barry, Political Free Riding, papers.ssrn.com/.
265
For example, if shareholders engage in derivatives transactions that
significantly increase their economic ownership in the corporation, there could
be multiple shareholders that each possess an economic interest equivalent to
holding a majority of the company's outstanding shares. See Part II.C, supra.

52

achieved without decoupling. For example, in the factory example

discussed above, GiantCo could pay FirmCo not to open the
factory. In the Alice and Paul example above, Alice could simply
tell Paul what she thinks is best, and Paul can vote accordingly.
Nonetheless, decoupling may offer significant efficiency
benefits in practice. A number of real-world frictions can
constrain the actors ability to enter into arrangements like those
discussed above. Actors may have limitations on the size of the
portfolios they can hold, such as from regulatory restrictions266 or
takeover defenses such as poison pills.267 They may face credit
constraints.268 There may simply be high transaction costs.269
Decoupling offers another mechanism for actors to pursue their
goals. And, since trades executed on an exchange are generally
extremely low-transaction-cost transactions, there is particular
reason to think that decoupling may increase the parties ability to
reach more efficient outcomes.
B. Implications for Securities Regulation Policy
The core outcome framework has significant implications
for securities regulation. We consider two types of regulation:
disclosure rules, which merely require actors to report their
activities, and substantive rules, which impose limitations on
conduct.
1. Disclosure Rules
The core outcome framework has important implications
for several major disclosure design questions. We focus our
analysis on three chief insights: First, the core outcome framework
266

Cf. PARTNOY, supra note 8181 at 87 (discussing regulatory restrictions on the

types of investments certain actors can make).
267
The poison pill is the most important takeover defense. It discourages a
would-be acquirer by threatening her acquirer with dilution (the poison) if she
reaches a certain threshold of ownership (i.e., swallows the pill). See generally
Barry & Hatfield, supra note 144 (providing background).
In some
circumstances, a pill can be triggered by a share ownership threshold as low as
5%. Selectica, Inc. v. Versata Enterprises, Inc., 2010 WL 703062 at *8 (Del.
Ch. Ct. 2010) (upholding such a poison pill).
268
Credit constraints refer to an actors inability to borrow money. See Francois
Ortalo-Magn & Sven Rady, Housing Market Dynamics: On the Contribution of
Income Shocks and Credit Constraints, 73 REV. ECON. STUD. 459 (2005)
(exploring the effects of credit constraints).
269
See Coase, supra note 116 (highlighting the importance of transaction costs).

53

gives a previously unrecognized reason for disclosure. Second, it

indicates what type of disclosure is necessary. Third, it suggests
that voluntary disclosure by private actors is unlikely to be
sufficient.270
These insights strongly support a mandatory
disclosure regime.
To understand what an appropriate disclosure regime
should look like, it is first necessary to understand why disclosure
is valuable at all. Recall that the key intuitive difference between
core outcomes and competitive equilibria is that, in a competitive
equilibrium, anyone can always buy or sell an asset271 at its market
price.272 This price is based on actors expectations as to the
decisions firms will make. Competitive equilibria frequently do
not exist because of the Bet and Switch strategy; a person with
control power can profit by making counter-expectation
investments and then changing firms decisions. The greater the
extent to which control rights are transferable, the easier it is for an
actor to acquire control power and execute this strategy.
The Bet and Switch strategy generates profits for the actor
with control, but when this strategy shifts the market away from an
efficient result, those profits come at her counterparties
expense.273 If those counterparties had realized what the actor
acquiring control was doing, they would not have agreed to
transact. However, the competitive equilibrium framework, which
allows unlimited purchases and sales at market prices, does not
account for this. The core outcome framework restricts the Bet
and Switch strategy because the would-be Bet-and-Switcher must
induce other actors to join her coalition (to be her
counterparties)and they will not be willing to do so if the Bet
and Switch will leave them worse off. Bet and Switch is only
viable in the core outcome context if it makes all the defectors

270

We do not discuss the important practical question of how best to design a

well-functioning disclosure system. We note that other commentators have
carefully considered this issue and have put forth detailed proposals. See, e.g.,
Hu & Black, supra note 1; Hu & Black, supra note 8.
271
Or a control right, to the extent that they are transferable.
272
See Part IV.A, supra.
273
This is a slight simplification; in some instances, her counterparties could
profit as well, but others would suffer larger losses. Those others would then
have an incentive to co-opt the counterparties and shift the market outcome.

54

better off, which generally entails moving the market to a more

efficient outcome.274
This insightthat socially inefficient decoupling behavior
generally requires some actors (counterparties) to voluntarily
engage in transactions that are not in their intereststrongly
supports disclosure. Presumably, these actors are only acting
against their interests because they do not realize what the holder
of control rights is doing.275 If the holder of control rights must
publicly disclose her actions, potential counterparties will no
longer be ignorant of what is happening and their role in it. Thus,
it will be very difficult for the holder of control rights to find
willing counterparties and, without them, she cannot execute the
Bet and Switch.276 In that case, we can be confident that the
market will reach and remain at a stable and efficient outcome.277
In addition, for actors to move a market to a core outcome,
or even to know that a core outcome has been reached, they must
have substantial information about each others economic interests
and control rights.278 In short, actors must know who holds control
rights and anticipate how those rights will be exercised. To do
that, they must know the economic interests of those actors holding
control rights. They must also know the economic interests of
other actors who might be able to induce control rights holders to
change their votes. For example, suppose Alice has a large
negative economic interest in a firm and Bob holds control rights.
274

This is a slight simplification; if the market is not at a core outcome, it is

sometimes possible to assemble a group that can profitably implement the Bet
and Switch strategy while moving the market to a less efficient result. However,
another Bet and Switch will then be possible that moves the market to a core
outcome. Once a core outcome is reached, it is no longer possible to assemble a
coalition that can profitably implement a further Bet and Switch.
275
POSNER, supra note 136, at 23 (discussing the pervasive classical economic
assumption that actors are self-interested).
276
Cf. George A. Akerlof, The Market for Lemons: Quality Uncertainty and
the Market Mechanism, 84 Q.J. ECON. 488 (1970) (showing how markets can
unravel when parties have asymmetric information about values); Paul Milgrom
& Nancy Stokey, Information, Trade and Common Knowledge, 26 J. ECON.
THEORY 17 (1982) (presenting a result, known as the no-trade theorem, that says
that under certain conditions, financial markets will produce no trades because
any offer to buy or sell conveys information to counterparties that they would be
foolish to accept the offer).
277
See supra Parts IV.B-C.
278
More precisely, it must be common knowledge. See DREW FUDENBERG &
JEAN TIROLE, GAME THEORY 541-46 (3d ed. 1993) ([C]common knowledge .
. . describe[s] the infinite regress of I know that you know . . . .).

55

Alice could induce Bob to vote against the firms interests by

entering into a derivatives contract with Bob that gives him a net
negative economic interest in the firm.279 To anticipate such
potential maneuvers and counter-maneuvers, all significant
economic interests and control rights must be disclosed.280
To be clear, it is not necessary to account for every
outstanding share of stock. So long as those who are not subject to
disclosure requirements do not have economic interests or control
rights large enough to disrupt firms decisions, the core outcome
framework should hold up well.281 Thus, there is no need to
burden small shareholders with potentially onerous disclosure
rules.282
This raises the question of whether it is necessary to impose
disclosure rules on anyone:283 If disclosure leads to efficient
results, can market participants, left to their own devices, be
expected to make sufficient voluntary disclosures, obviating the
need for a mandatory regime?
Although our models do not speak to this directly, we do
not believe that private disclosure will generally be sufficient. An
actor who can disguise what she is doing and deceive her
279

This essentially allows Alice to share with Bob the gains she receives if the
firm does not make decisions that maximize its value.
280
More generally, making actors aware of each others holdings makes it less
likely that they will experience an inefficient outcome they could have avoided.
281
See APPENDIX, supra note 33, at 1.2, 2.2.
282
We note that disclosure need not necessarily come from shareholders. If
transactions must be conducted through an exchange, the exchange would be a
party to all transactions. Accordingly, it could potentially keep an automated,
publicly available, up-to-the-minute account of all parties positions.
283
There is a longstanding debate about when mandated disclosure is preferable
to relying on private parties self-interest inducing them to make disclosures.
See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a
Mandatory Disclosure System, 70 VA. L. REV. 717 (1984); G.J. Stigler, Public
Regulation of the Securities Markets, 37 J. BUS. 117 (1964); G. BENSTON,
CORPORATE FINANCIAL DISCLOSURE IN THE UK AND THE USA (1976); G.
Benston, The Costs and Benefits of Government-Required Disclosure: SEC and
FTC Requirements, in CORPORATIONS AT THE CROSSROADS: GOVERNANCE AND
REFORM 37-69 (D. DeMott ed. 1980); G. Benston, Required Disclosure and the
Stock Market: An Evaluation of the Securities Exchange Act of 1934, 63 AM.
ECON. REV. 132 (1973); G. Benston, The Value of the SEC's Accounting
Disclosure Requirements, 44 ACCT. REV. 515 (1969) See H. Manne, Insider
Trading and the Stock Market (1966); H. MANNE & E. SOLOMON, WALL STREET
IN TRANSITION: THE EMERGING SYSTEM AND ITS IMPACT ON THE ECONOMY
(1974). Schotland, Unsafe at any Price: A Reply to Manne, Insider Trading and
the Stock Market, 53 VA. L. REV. 1425 (1967).

56

counterparties into transacting with her may be able to reap very

large profits through the Bet and Switch strategy. Thus, she will
not want other market participants to be aware of her overall
position, and will conceal it as best she can.
Of course, her counterparties, and potentially other market
actors, will have incentives to uncover what she is doing, or to
require her to disclose it to them. Thus, the market should produce
some degree of private disclosure.
However, there are several problems with relying on the
market in this instance. First, disclosure to counterparties
generally is not sufficient. For example, a party with a negative
economic interest may be able to co-opt counterparties and employ
the Bet and Switch strategy, to the detriment of other actors with
larger positive economic interests.284
Second, investigating
counterparties holdings may be costly. This could produce a freerider problem that would prevent private disclosure from working
well.285 This is particularly likely to occur if a single actor has a
concentrated economic interest while the opposite economic
interest is dispersed across multiple actors.286 Finally, it is worth
noting that there have been instances in which traders successfully
deployed and profited from deceptive tactics, even when
counterparties were primed to expect them.287 Thus, we believe
that mandatory public disclosure will augment available
information and may produce benefits.
Finally, one might be concerned that a comprehensive
disclosure regime will discourage actors from gathering
information,288 and that this will outweigh the benefits of
disclosure. An alternative approach would be to pair retroactive
disclosure requirements with a legal rule that penalizes actors who
employ the Bet and Switch strategy unless they can establish that it

284

See the text accompanying note 279 for an example.

See BAINBRIDGE, supra note 35, at 35-38 (discussing free-rider problems
among shareholders).
286
See generally MANCUR OLSON, THE LOGIC OF COLLECTIVE ACTION; PUBLIC
GOODS AND THE THEORY OF GROUPS (1971) (analyzing this dynamic).
287
See PARTNOY, supra note 81, at 21-23 (discussing examples of successful
misdirection in unregulated markets).
288
See note 146, supra, and accompanying text.
285

57

was socially beneficial.289 This could potentially discourage

socially inefficient market manipulations without diminishing
parties incentives to gather information about securities values.
However, a court or agency might have difficulty evaluating
whether particular behaviors were good for society.290
2. Substantive Intervention
Some commentators have called for substantive regulations
to respond to decoupling. The core outcome framework could also
support substantive regulations, especially if it is not possible to
implement a sufficiently comprehensive disclosure regime at a
reasonable cost.
For example, other commentators have previously
proposed barring actors with a negative economic interest in a firm
from exercising control rights over that firm.291 The core outcome
framework could potentially support such restrictions, at least in
certain instances. Such prohibitions make sense if one believes
that the decisions that maximize the firms value also maximize
social utility. However, this approach would encourage inefficient
outcomes when the decisions that are best for the firm are not
socially optimal. Thus, under the core outcome framework, the
merits of this approach depend on the degree to which other
regulations are efficient.
The same issue arises with respect to commentators
suggestion that companies can manage decoupling through
corporate charter provisions.292 For example, a charter that barred
shareholders with negative economic interests from voting in
corporate elections would promote shareholder voting that
maximized the corporations value. However, if the corporations

289

Cf. Partnoy, supra note 115, at 254 (suggesting that ex post discipline by
courts can improve ex ante incentives with respect to derivatives).
290
It is also possible that an agency might be co-opted by those seeking to
engage in socially detrimental but privately profitable decoupling transactions.
This situation is known as regulatory capture. See Michael E. Levine & Jennifer
L. Forrence, Regulatory Capture, Public Interest, and the Public Agenda:
Toward a Synthesis, 6 J.L. ECON. & ORG. 167 (1990) (discussing the
phenomenon of regulatory capture).
291
See, e.g., Martin & Partnoy, supra note 8, at 793.
292
See Hu & Black, supra note 1, at 697-701.

58

interests conflict with societys, such a provision would be likely

to lower social welfare.293
Our analysis also has important implications for the design
of other legal rules. There are times in corporate law when a small
group of shareholders can block an action. These low thresholds
make the Bet and Switch strategy more attractive.294 Allowing a
small percentage of outstanding shares to block a transaction also
puts more pressure on disclosure rules: Uncertainty with respect to
the identity and incentives of relatively few small shareholders can
create uncertainty about the firms decision. Thus, more disclosure
is necessary to ensure a core outcome.
For example, in some jurisdictions, if an acquirer purchases
a sufficient percentage of outstanding shares, she can force the
remaining shareholders to sell. In Australia, the necessary
ownership is 90%.295 In 2005, Cleveland Cliffs attempted to
acquire Portman Mining, an Australian company.296 Seneca
Capital, a hedge fund, moved to surreptitiously acquire a blocking
interest.297 Ultimately, the two parties struck a deal.298 While this
illustrates how actors can voluntarily agree to move from a noncore outcome to a core outcome, this negotiation might not have
been necessary if the minimum ownership threshold were lower.
To take another example, some jurisdictions require
minority shareholders to overwhelmingly approve a takeover offer
from a majority shareholder.299 In the Henderson Investments

293

It could even lower shareholders utility as a class if shareholders nonshareholder interests dominate. For example, this could happen if a firm had
numerous shareholders, each of which held few shares, and the firms inefficient
action significantly affected the shareholders as employees or consumers.
294
To be clear, the Bet and Switch strategy will only be possible in this context
if the market expects the transaction to take place.
295
See Bryan Frith, Broker Goes For Broke on Portman Bid, AUSTRALIAN, Apr.
8, 2005, at 18.
296
Id. at 19; Bryan Frith, Cliffhanger As Clock Ticks in Portman Bid,
AUSTRALIAN, Mar. 17, 2005, at 24.
297
Frith, supra note 295, at 19.
298
Bryan Frith, Hauling Equity Swap Disclosure Over Coals, AUSTRALIAN,
June 8, 2005, at 36.
299
Several U.S. states have enacted anti-takeover statutes that prevent an
acquirer from taking certain actions for a period of time without a supermajority
vote of minority shareholders. See Harry DeAngelo & Edward M. Rice,
Antitakeover Charter Amendments and Stockholder Wealth, 11 J. Fin. Econ.
329, 348 (1983).

59

transaction discussed previously,300 90% of the outstanding

minority shares were needed to approve the transaction. Since
Henderson Land owned over 70% of Henderson Investments
shares, an actor could acquire the power to prevent the transaction
by amassing less than 3% of the outstanding shares.
Such circumstances seem ripe for mischief. In theory, the
core outcome framework predicts that disclosure is sufficient to
correct this problem. But, since any disclosure regime will always
fall short of the ideal, the wisest course of action may be to eschew
rules that enable such a small percentage of outstanding shares to
change outcomes.301 We further explore differences between our
idealized model and real-world markets below.
C. Relaxing Simplifying Assumptions
Our formal models make several simplifying assumptions
that are not strictly true in the real world. Chief among these are
assumptions regarding transaction costs and information.
1. Transaction Costs
Our competitive equilibrium and core outcome models
assume that there are no transaction costs. This is a common
modeling assumption, but is never strictly true in reality.302 While
public markets are generally considered to have very low
transaction costs, there are two types of transaction costs that we
believe may have significant real-world effects.303
First, buying and selling shares can entail commissions,
fees, taxes, and other monetary costs.304 As transactions get large
enough, counterparties become more difficult to come by, further
300

See McMillan, supra note 6 (discussing same).

To be clear, the same is true of rules that allow a very small percentage of
shares to approve an action. Such rules are simply less common.
302
Cf. Coase, supra note 116 (exploring the results that would flow if this
assumption were literally true in reality).
303
We note that the number of outstanding votes at any given time is fixed, but
there is no theoretical limit on the economic interest an investor could take on
through cash-settled derivatives, assuming that she can find enough
counterparties. Thus, in practice, there may be larger transaction costs in the
market for economic interests than for control rights.
304
See Burton G. Malkiel, The Efficient Market Hypothesis and Its Critics, 17 J.
ECON. PERSP. 59, 62 (2003) (discussing how such transaction costs can prevent
investors from profiting from small-scale market inefficiencies).
301

60

raising costs. The real-world effect of these costs is reduced

trading. This makes the Bet and Switch strategy less appealing and
generally makes the market more stable. In practice, this means
that these transaction costs render competitive equilibrium analysis
somewhat more meaningful.305
Similarly, by making trading more difficult, these
transaction costs undermine the core outcome frameworks
guarantee of efficiency. They also weaken its predictive power.
Intuitively, because transaction costs make it less likely that the
parties will trade their way to an efficient outcome, they increase
the likelihood that the market will remain stuck at an inefficient
result.
In short, these transaction costs help explain why
decoupling is not even more common than it currently is.
However, these costs have been dropping for a long period of time.
The growth of computerization and derivatives markets is a tale of
ever-falling transaction costs.306 This trend is expected to
continue, and decoupling to increase with it.307 Accordingly, we
do not believe it wise to place much reliance on these costs when
formulating policy.
Second, and in our view more troubling, there are
transaction costs for actors to coordinate their behaviors.308
Consider two outcomes, one more efficient than the other.
Compared to the efficient outcome, the inefficient outcome lowers
many actors well-being by a small amount but raises one actors
well-being by a large amount.309 Without transaction costs, the
many hurt actors should be able to band together and correct the
inefficiency. In practice, however, the costs of organizing a large
group of actors may be prohibitive and the market may remain

305

This is a somewhat surprising conclusion, since transaction costs generally

impede markets from reaching competitive equilibria. See Coase, supra note
116.
306
See Hu & Black, supra note 8, at 3.
307
See Part II.C, supra.
308
This problem is related to the free-rider phenomenon discussed earlier. See
Part V.A, supra.
309
Such a scenario also raises fairness concerns if the winners are likely to be
large and sophisticated while the losers are smaller and unsophisticated. See
Part II.D, supra.

61

stuck at an inefficient outcome.310 Recall the prior example of the

new factory that benefitted its owner but whose pollution imposed
large costs on a rival business.311 If those costs were spread among
many smaller businesses or individuals, it might be quite difficult
for them to jointly orchestrate an empty voting campaign.312 Thus,
if policymakers decide to impose substantive regulatory measures,
they may wish to tailor them to address such instances.313
However, we note that while many envision public markets
as full of relatively small shareholders, this view is incomplete in a
key respect. Most small securities investors invest through
institutional intermediaries such as mutual funds, pension funds,
and other financial services providers.314 Thus, forming coalitions
may not be a matter of organizing thousands of small investors, but
merely organizing a much smaller group of sophisticated
intermediariesa far less daunting task.315
2. Information
Our models make two key assumptions with respect to
information. The first is that all parties know and agree upon each
assets value under every firms potential decision. In reality,
actors value estimates are likely to diverge to some degree.
Variation among actors value estimates is not a
fundamental problem for our approach. In the Appendix, we show
that, when parties have a range of beliefs about values, the models
predictions remain intact with only slight modifications.316 More
specifically, the market reaches the outcome expected to be
310

The market may also be shifted to an inefficient outcome in a similar manner;

the Bet and Switch strategy resembles this process in reverse.
311
See Part V.A, supra.
312
It is worth noting that some investors do take a similar approach, and that
there have been instances in which similar approaches have been successful.
See Katherina Glac, The Influence of Shareholders on Corporate Social
Responsibility, History of Corporate Responsibility Project Working Paper No.
2 at 4-14, available at cebcglobal.org/ (giving brief history of shareholder
activism); id. at 13 (discussing how environmentalists used shareholder voting
mechanisms to effect policy changes at Amoco in the 1990s).
313
We note that this is broadly consistent with the SECs investor protection
mandate.
314
Cf. Global Macro Monitor, Who Owns the U.S. Equity Market?, THE BIG
PICTURE, available at ritholtz.com/blog/ (showing the relative U.S. equities
ownership of different types of investors in 2011).
315
See OLSON, supra note 286.
316
See APPENDIX, supra note 33, at 1.3.

62

efficient, given the parties various beliefs.317 Assuming that the

parties beliefs about values are correct on average,318 the models
predictions are largely unaffected.319
The second information assumption that our model makes
is that every actors securities holdings and incentives are common
knowledge.320 This assumption is more problematic. Any realworld disclosure system is likely to be imperfect. Even if
disclosures are perfect, some actors may not stay abreast of them.
Moreover, public disclosure of financial holdings does not
necessarily provide clarity with respect to every actors incentives.
For example, an employee holding stock in her employer may be
inclined to vote against a takeover offer that is in her interest as an
investor out of concern that the takeover could lead to layoffs.321
Similarly, an investor who has a client relationship with a firm may
vote with management to protect that relationship, even if it cuts
against her interests as an investor.322 Disclosure regimes often do
not capture these types of interests.323
More generally, issues of uncertainty compound each other:
For example, consider an investor who owns stock in a corporation
and its largest customer, but who has a negative economic interest
in its largest supplier. It may be difficult for other actors to
anticipate how such an investor will vote in a particular instance.
It will be especially difficult if some of these interests are not
disclosed or if opinions differ as to how a decision will affect these
various firms. Meanwhile, some investors may not have to make
any disclosures at all.
Uncertainty about separate blocs of voters magnifies
uncertainty about the ultimate outcome of the shareholder vote.
317

See APPENDIX, supra note 33, at 1.3 thm 3.

Alternatively, the model holds up if actors beliefs are inefficient, but are the
best predictors of value available.
319
See APPENDIX, supra note 33, at 1.3.
320
See FUDENBERG & TIROLE, supra note 278, at 541-46.
321
Acquisitions often involve consolidating two companies and reducing the
number of personnel. Acquirers often replace many of targets managers and
employees. JOEL M. STERN & DONALD H. CHEW, THE REVOLUTION IN
CORPORATE FINANCE 563 (2003).
322
See BNS Post Says U.S. Hedge Fund Looks to Block Sears Deal, supra note
104.
323
See Hu & Black, supra note 8, at 866 tbl.3 (illustrating how U.S. disclosure
laws do not require complete disclosure of all potentially relevant interests).
318

63

For example, if the interests of voters holding 5% of control rights

are uncertain, to know whether a measure will receive a majority
of votes, one must be confident that slightly more than 50% of the
remaining voters will vote a particular way.324 But, if 25% of
voters interests are unclear, one must have confidence that the
remaining voters favor a particular outcome by a two-to-one
margina much higher threshold.325
Thus, these factors multiply the uncertainty that actors face
in the marketplace, undermining the conclusions of the core
outcome framework. Yet, as long as disclosure is good enough
meaning that it conveys enough parties interests with sufficient
certainty in a large enough percentage of casesand many actors
pay a reasonable amount of attention to them, the models
predictions will endure. Those instances in which disclosure is not
likely to meet this threshold may be most suitable for substantive
regulatory intervention.
VI. CONCLUSION
The core outcome framework espoused in this Article gives
significant insight into the thorny and increasingly prevalent issue
of decoupling. Shifting away from the concept of competitive
equilibrium and toward the core outcome framework offers
policymakers and scholars a number of benefits. Competitive
equilibria lose most of their desirable properties when control
rights are introduced, and generally cease to exist at all when
derivative markets grow large. Core outcomes, on the other hand,
always exist, are always efficient, are stable, offer significant
predictive power, and resemble observed real-world behavior.
Moreover, we show that, in the absence of transaction
costs, knowledge of all major market participants economic and
324

To be confident that shareholders will choose a particular option, one must be

confident that more than 50% of outstanding votes will be cast in favor of that
option. If 5% of votes cannot be predicted, then the requisite support must come
from the other 95% of votes outstanding. Thus, one must have confidence that
52.6% of this latter pool of voters favors a particular outcome, a relatively slight
increase above 50%.
325
Again, one must be confident that more than 50% of outstanding votes will
be cast in favor of the relevant option. If 25% of votes cannot be predicted, then
the requisite support must come from the other 75% of votes outstanding. Thus,
one must have confidence that 66.7% of this latter pool of voters favors a
particular outcome.

64

control rights is both sufficient and essential for achieving a core

outcome. This strongly supports a comprehensive and effective
mandatory disclosure regime.
Such a regime allows for
decoupling in those situations in which it is socially beneficial, and
only in those situations. Since private parties left to their own
devices would generally not engage in such disclosures, the core
outcome framework provides a strong justification for a fulsome
mandatory disclosure regime for securities and derivatives
markets.

65